Traditionalists Ask “Why?”

Happy Columbus Day. Remember to feed the meters even though all public employees are enjoying a paid Holiday. More on that later. The market had a huge rebound week last week, and we are on the verge of totally forgetting that nasty, and ultimately forgettable to some, sell-off of the last two years. The SPY rallied from 102.49 to 107.26, a very large weekly move of 4.7%. The VIX was pummeled, starting the week at 28.68 and finishing 19% lower at 23.12. So we are to believe that not only is the market going straight up, and your investment in the market worth more, the insurance on the now higher value should be less. I thought the market was supposed to be rational? To give you an example of what I mean, last March when the SPY was under 70 (admittedly a tough time), the December 70 puts of 2011 were roughly 19.50 (we should have sold them). That means you would not even break even on your puts until the SPY was under 50, an additional downward move of over 28% (and the world in financial chaos). A level of 50 would also be a level not visited since September 1958. Now the SPY is 107.26, and the December 2011 110 puts are 17.70, which means the break even is roughly 90, a move of only 16%, and a level we were trading only 90 days ago. Who says markets are rational? Maybe that is why it is possible to make money.

I would certainly say that the market has had a tremendous rally off the March lows, really without any real fixes to the basic problems that brought us to that abyss. It seems that the very action of the market going up, with the accompanying increase in wealth and the buying power that it gives, is being judged a fix in itself. The market is going up, so something must be better, and I better get on board or I will miss it. Who cares if I actually felt nervous about investing at 70, this 107 looks good now. What do we know for sure? I think we know that the financial system is in better shape than in March, and appears to be in no danger of falling apart in the near term. That “stability” has been “bought” by an incredible (if you don’t believe the word incredible applies, tell me what a trillion or so dollars means to you) shift of financial system problems to government debt (meaning our debt). That is coming at the expense of dwindling dollar value, meaning our net worth is actually declining in world terms, and massive future tax liabilities (even some dopey neocon knows you essentially have to pay for something eventually). Right now this is being cheered, since U.S. multi-nationals benefit by the weaker dollar (to a point). The idea is that since the U.S. investor that happens to own some stock in one of those companies benefits some, that somehow we all are ok. Nice try!

The interesting thing this time (and there was a last time, the Resolution Trust era of the early 80’s) is that a lot of the “taxes” we will pay will not be labeled as such. Instead of us having our taxes raised by the Federal Government (we will see that soon) we are re-floating the banking system internally so they can pay back the government in lieu of taxes. A large and non-competitive banking system is being allowed to suck the financial life out of the citizenry and add nothing to any real economic solution (like creation of capital for small business). How else can you explain virtually no interest on demand or savings deposits, yet relatively high rates and stiff conditions on any sort of loans? Don’t even think about the poor nitwit (and I do not mean to insult) who may have $200,000 in a Citi 90-day CD IRA at 2.2%, while carrying a $15,000 credit card balance at the same bank at 21% . That leaves him or her receiving $4,400 on $200,000 while paying $3,150 on the $15,000, and don’t be late with a payment. Happy retirement. Also, don’t say you have an entrepreneurial idea. They will not help.

In my lifetime we have had a massive bailout of the financial system once before, the Resolution Trust. Briefly, the Federal Reserve (although they would never admit to it) threw an inordinate amount of money at an economy with severe structural problems. Instead of that money causing an increase in real growth (sound familiar) it caused a spike (helped along by increases in oil prices from OPEC) in inflation. That inflation caused financial institutions to pay high interest rates to attract deposits, sometimes as much as 10-12%. Those rates created a disaster in institutions (mostly Savings and Loans) that were using those short-term deposits to fund longer-term mortgages in the 5-6% range. Anyway, the system virtually collapsed and was replaced by the packaged mortgage system (collateralized debt obligations) that blew up this time. How was that  trade in systems work out?

The point here is that we (meaning you and I) end up paying dearly for these fiascos. For a long period of time in the 80’s Banks had over 50% of their assets in Government obligations, meaning that they were being allowed to re-float their balance sheets by gathering relatively low cost deposits and short-term governmental loans and invest longer-term in governmental paper, meaning they were essentially scalping governmental paper instead of giving loans. That meant that Banks were not lending to people and businesses, there were an awful lot of good ideas that were unable to find capital, a lot of jobs that did not get created, a lot of entrepreneurs that should have been and never were. Growth in the 80’s should have been much more robust if it were not for the combined financial system/government combined disaster and recovery. Here we are again, bigger to the almost unimaginable degree, but the dumb solutions remain the same. In fact it is worse, banks are bigger and more concentrated. The idiots that run them are paid more, and they are into the average American with credit cards and other loans to a much greater extent than the 80’s. Plus the housing stock has had an equity collapse that did not happen in the 80’s. Yet somehow a rally in the market will fix all this, or cause us to ignore everything that remains to be done. I hope so, but it sure seems like a lot to ask.

Yet, can something be different this time? Maybe. It might very well be possible for some of the concentrated industries that have pricing power (banks, some chip makers, multi-national construction, etc) to leave the rest of society at the gate, at least for a while. Maybe the 10% unemployment and general malaise of a large chunk of the population will not affect them, especially if the rest of the world starts to rebound. I do know that the financial press, and way more of the elected officials than I would like, seem to be controlled by the “wealth” class rather than the “working” class. It certainly is possible (has happened before) for the banking industry to do very well while not spreading that wealth around. I do think it might be possible for some segments of the market to keep going up while a lot of us traditionalists look around and ask “Why?” The nagging feeling that growth will be severely retarded going forward due to the necessity of a financially wounded population having to recap some while having restrictions on access to capital is just something I am going to have to fight in this potentially “new” world.

As for the market, it sure is tough to fade. We have been successful in the PIP in putting an additional spread on top of the market in an attempt to stay long during this steep advance, and may have to continue to do some imaginative things to stay at least somewhat long. If the puts continue to go down in value (VIX keeps falling) we may actually commit some of the extra cash some of you have in your accounts, and may in fact buy some extra puts in the process. I still am not a long term believer in this dollar goes to zero while market goes to the sky philosophy. If it does I certainly will have to send out a few letters to people that have written Economics textbooks and advise they revise a few chapters.

For those who watch the financial news and somehow feel that everyone should be rich with the recent rally, be reminded that in the last 16 months the SPY is still down 20%. By being hedged those in the PIP Program (depending on when you started) are down some fraction of that amount, and were spared the nightmares of being down almost 50% last March. We certainly have not changed our view that we need to be protected given the recent rate of run-up, but will continue to adjust the positions in an effort to participate should the run-up continue.

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