The Prognosis Going Forward
January 3, 2012
Good morning, and Happy New Year. There is not much to say about the market totals, either last week or last year. Last week the SPY was up a whole .09 to close at 125.50, making it down .25 for the whole tumultuous year. The market closing virtually unchanged after a year that saw a high of 137.18 on May 2 and a low of 107.43 on October 4 almost feels like someone’s idea of bad humor, but that is the tale of the tape. The VIX did close up 5.64 to 23.79 (32%), but even that increase does not even hint of the whole story that saw the VIX spot value see a low of 14 on April 28 and a spike high of 48 on August 8. All of us remember days when the market traded up huge and down huge, maybe several times, only to close little changed, but having a year like that seems a little strange. It sure seems like an awful lot of work and worry went into what the history books will show as uneventful in the aggregate. It also tells the story of the market really since December of 1998, hardly any change but a lot of movement in the meantime. Going back that far you have highs in early 2002 and again in early 2007 of over 150, and the so-called Lehman lows in early 2009 of under 74, but basically unchanged over a 12 year period. That record seems to scream for hedging, protection, maybe some short term trading, and surely questions the traditional buy and hold theories.
Even more worrisome is that we are talking Index averages, specifically the S&P 500, and are not accounting for the seemingly unusually high number of single stock disasters. If you were invested in the S&P 500 during this past 12-year period you would be whole, barely, but without some sort of protection (like the Protected Index Program) your portfolio would have had some dramatic swings in portfolio value. If you had been in individual stocks I can’t remember a similar period where holding some traditionally sound stocks could have been more of a disaster. Starting the period (Jan, 1999) with a portfolio of General Motors, K-Mart, United Airlines, Bear Stearns, Lehman Bros., Citigroup, Hovnanian, Fannie May, and a few assorted tech stocks would not have seemed so terrible, but let’s hope for your sake that you had not resigned your day job. If not, you are broke. I can’t even remotely remember a time when so many well thought of and storied companies ended up worthless or close to worthless, and those disasters are only anecdotally accounted for in the gross market averages. I am still a huge believer in the idea that one of the largest strengths of the American way of life is the relatively easy ability for regular people to own and share in the ownership of the large companies that are the backbone of American industry and service. On the other hand, other than some (sometimes seriously good) short term trading opportunities it is hard to argue, given market performance for the last 12 years, that someone had or has great urgency to enter the market as a long-term investor.
So what is the prognosis going forward? Is it finally time for the market to begin an advance that will “catch up” to both the recent earnings growth in the S&P 500 and over a decade of stagnation in market averages? Everyone would sure like that to happen, and maybe we are seeing some of the early beginnings of some long-term market and economic growth and health. I admit to being very confused, I am cheered by the unmistakable upward creep in some of the economic numbers but am sobered by the amount and duration of unsustainable stimulus seemingly necessary to “purchase” this fragile and meager growth. Call me picky (or prickly) but you would think a money supply growth over 10% and Federal deficits of around 8% of the GDP would surely “buy” more than a 1.8-2% growth in GDP. If the recent economic numbers do signal a return to “more normal” times including interest rates how exactly is the Fed going to pay for the additional interest costs of their $16T borrowing that will surely come with “good times” (average borrowing costs up 3% is $480B per year in increased borrowing costs)?
Having said all that, the only way from zero growth to solid growth is to go through slow growth for at least a little while, so what we are seeing is positive. If we could only make some progress politically maybe it can be sustainable.
Politically, what is the situation? I believe the current economic situation has been totally misread by virtually everyone in power for a period of years, on both side of the aisle. It is compounded by “influence” groups that have been able to affect through the political process policy changes that have even more seriously skewed the negative effects of the problems onto various hapless groups. On the national level big Banks have jammed through policies resulting in virtually zero borrowing costs for them with the resultant zero income on money balances for the rest of the population This has devastated the average saver and retired person and benefited the Banks big time. Big Corporations have “found” ways to pay virtually no taxes in some cases, both Federal and local, increasing the burden (either now or someday soon) on the rest of the population. Those in the local and state public arena have used their political influence to seriously warp the public/private balance in many communities, where seemingly unthinkable things (like 40% decreases in average property values combining with only 1% average decreases in property tax revenues) have taken place. InIllinois(hopefully a singularly corrupt State) the interplay between public and private well being would be almost laughable if not so devastating to some. The “average” wage earner (making around $35,000 per year gross) is piling into the New Year with an 85% vehicle toll increase, a potential $500 annual parking increase, and/or a 30+% increase in train fares, a further .6% decrease in home values in November, either an increase or no decrease in property taxes year over year, an average 10+% increase in health care, all washed down with a maybe .1% increase in wages in November. The ability of the power elite in both Corporate and Public America to increase prices, fees, and taxes seemingly with impunity to keep their status quo is both impressing me and scaring me. People seem powerless to fight it, and I don’t like people being powerless, this is, or was,America. I had “occasion” to watch one of those mindless daytime TV things yesterday and they were interviewing people inChicagoabout all the parking meter and toll increases, and every person expressed some idea of unfairness, outrage, or whatever, but not one even remotely mentioned any possible redress through the political process. Every one said some version of “there is nothing you can do but accept it.” Not one said, “I am going to find out who voted for it, write the bastard, and work to get him or her out.” Are we that lazy or intimidated? Maybe so, the couch, the malls, and Fantasy Football are strong attractions.
Will the elections change our direction? It could, but I have not heard any hint of a candidate that has talked (or been able to talk, given the system) at length about the current economic issues or any plans to change direction. I am not sure it is possible to get from extreme stimulus leading to a debt disaster someday to a sane budget while maintaining fragile growth along the way. One huge advantage is the timely end of theIraqwar, even with the huge waste and corruption involved in giving/leaving the billions of valuable assets behind. In any case, the War’s end is a huge help in the deficit war and should be a start to more sane numbers. Maybe it can be done, with the right people at the helm we could get from here to where we would like to be, but I don’t see that person anywhere, just the same old faces selling out to the same old interests. Just look at the similarities in how the Banking and Oil industries have been treated by the supposedly ideologically different Bush/Obama teams; I see no difference at all. Those people own the place, and the people in the place, including the Oval Office. Do I see someone out there that will restore interest income to my clients by increasing borrowing costs to Banks, or tweak Big Oil by giving give natural gas a chance, not a chance. Teddy Roosevelt is dead and buried, and none of the Obama, Mitt, Newt, Huck, and etc. group has a tenth of his backbone.
So what can we do? Well, we can make some money, no matter what the market does. Last year the standard SPY PIP virtually mimicked the SPY in returns, with substantially less volatility. We always said that if the PIP does as well as the underlying benchmark with less volatility and the ongoing protection it provides it is a very good deal. Having said that, I am never happy with just matching the market. It is true that we did better in some of the offshoots of the PIP last year, those in the XLE, IWM, and the new dividend program for example, but the fact is that the low interest rates are wearing on both the call sales (lower interest rates lower call prices) and the relatively high prices of protective puts that we purchase. The long term put protection, for the 12 year life of the PIP Program, have averaged somewhere around 11-13% of the asset value for the 24-30 month out put, now it seems locked in the 15-19% range, a serious increase. It is impossible for most of my clients to seriously think of investing in this volatile market without protection, and the cost of protection is up. You can just feel the pressure as being bigger, and the risk bigger. We did not go home some days last year wondering whether IBM earnings would be good or great, we went home wondering if we would lose a country overnight, or whether people here on pensions would fail to get checks. There were some huge moves overnight in Stock Futures, days in a row at times that rivaled movement historically in weeks or even months, very hard to maintain a position. It does not surprise me that protection is expensive, but I still do not like paying more.
The VIX had very large daily and long-term swings, some days it was possible to be long call options on big up days with little profit as the VIX would implode on rallies. When the VIX would explode on down moves there was advantage in being long individual options to benefit by the double move, when the VIX would decrease it was more advantageous to have used a spread position, hard to predict. Technical traders would have many buy or sell points work in a row, only to be buried as one buy point was submerged by a double digit Futures move overnight. A fundamental trader (like I tend to be) found the year very difficult, as movement in one stock (even in a similar industry) die not preclude a move in a similar stock. For example, look at the difference in performance this year in IBM and HPQ. Management advantage to IBM for sure, but IBM at 13.7 P/E up 25% on the year, HPQ at 8 P/E down 38% seems a little harsh, and frustrating.
Advantages? There are some. The addition of the weekly options expirations bode well for covered call writing against long-term positions (like the PIP) going forward. There also seems to be some theoretical edge in the weekly calendar spreads from time to time. We will to look for situations with some volatility edge, and try to have some advantage when initiating positions. Although we have had uneven success so far, I think it is very important to monitor the prices in the long-term bonds, I feel very strongly that the economy will not be able to break out significantly to the upside without interest rates creeping to “more normal” levels. Anyone still with long-term positions in fixed income should evaluate the risk in those positions, and either consider lightening up or protecting. Any sudden moves in interest rates will severely impact long-term bond prices. Do not give those profits back!
We are here to talk about individual strategies for the New Year, and we will be looking to find ways to more aggressively trade these violent market swings with relatively low risk spread type positions. We missed a few swings last year by underestimating the sheer size of the snap back moves, we will give some more room when playing those swings this year. Last year was tough, but our strategy of protection kept us out of the disasters and virtually all of out powder is dry. I am sure a lot of people are very jealous of our performance last year, but I am not satisfied. We want to be protected and make money as well; we need to make up some for the lack of interest income that most of our clients are feeling. We also need to somehow overcome the initial high price of the put protection, and will have to pick our spots to initiate trades. We also have to be aggressive and take any spikes in call prices the market may give us. This year might be all ours.