What is Happening?

Good morning. It is hard to even describe what happened in the market/world last week and the ramifications it may have on the economy and individual wealth going forward. The market had a horrible week, with the SPY down 7.2% to close at 120.08. The volatility index (VIX) closed up 27% on the week to close at 32, a level not seen since June 2010. Maybe even more amazing, since the focus of the week was the impending downgrade of the US credit rating, the 30-year bond was up over 3% on the week to close at almost 132, representing a 30-year yield of 3.8%.  Returns on short-term US Treasuries flirted with the negative level as people around the world rushed to safety in a country about to be downgraded. The actual downgrade did happen after the close last Friday, as S&P (after sending numbers to the Treasury early in the day) moved the US credit rating from AAA to AA+. So far this morning the markets around the world are sharply lower, although the interest in the actual US Treasuries remains strong. It really did not matter the strength of the individual security last week, as waves and waves of selling in the Futures contracts brought about significant program selling in the individual stocks, making it hard for even the best situated companies to stand tall. Maybe now it is the time to see if any individual stocks were driven down so far as to be attractive.

What is happening? We had a long period of struggle in Washington before a last minute extension to the debt ceiling was finally passed. During the “debate” an awful lot of the normal posturing and infighting between the various factions was televised and otherwise documented for all to see. I am not sure what people expected to see when 535 people (House and Senate) from very diverse backgrounds and positions (and on serious issues) try to come up with a plan going forward. I think the infighting is always there, and is actually designed in, so we should change our focus from the process to the result. I actually think that one of the results of the debate, the so-called Committee set up to cut an additional amount by November that has to be addressed in its entirety is very positive. Going back in history I think most can remember that it was virtually impossible to ever close an obsolete military base. Every legislator whose district or state was affected would marshal any support or favor owed him or her to stop that closing. After a while the solution was a committee designed to review all the bases, which would come back to the full Congress with a list of closures that could not be amended, but required a vote on the complete list. So, in theory, this group could come back with some cuts in egregious spending, some cuts in abusive tax loopholes, and some real cuts in some entitlements out of control. That combination would have to be voted on, without the ability of groups to pull out the pieces they do not like. I think it could be (repeat, could be) a huge step forward. The criticism is that it is way too little, way too late, and might not work. If it does not, at $100 B a month, the problem in November is now close to $15 B instead of $14.4 B.

Is the leadership really as inept as is generally believed? Can they be counted on for the “solution?” I do not think they are as inept as they seem, on the contrary they are amazingly adept at “delivering” to those who support them and maintaining their personal influence. My concerns are that the problems are too wide, and too structural, and way too far-reaching for the current cast of characters to get their hands around. There are many who are still bleating and tweeting one-liners like “Cut taxes,” “Term limits,” “Tax Corporate jets,” “Throw them all out!” These problems are enormous, starting with the people either unemployed, under-employed, or with static income, moving on to those losing a significant amount of personal equity in his or her house, and now seeing consumer prices increase and the stock market decline. The notion that the huge and powerful multi-national companies are immune to anything that happens to the rest of the economy is also being called into question as the market declines.

So what is the downside of the “style” of leadership we have? I think, with all the photo-ops, and voice ops and campaigning constantly going on, and the absurd numbers of lobbyists monopolizing the time of elected and appointed officials we simply do not have the time (or the will) to change anything. Sometimes that is a positive, but not now. The old joke that no one was safe when Congress is in session better not be correct in the current situation (even though it seems so). I remember my mother telling me (no wonder I think like I do), “I get so tired of these supposed big shots getting paid so much to be in charge, and the first time the crisis hits and you need this supposed expertise that you have been paying for all along, they have nothing.” Do our elected men and women, including the President, “Have nothing?” Somehow, at every level, we need to get control of government and where it is headed. I will take a stab at the following six things that absolutely have to happen to turn this slide around. I would love your feedback.

1) We have to get a handle on cheating and fraud. I am very aware that the fraud component of government at every level is probably not a great percentage of the deficits in terms of money, but it is in terms of perception. We can’t have the cascade into the social realm of “You aren’t cheating, you aren’t trying!” Psychologically we need to find the people in Iraq that stole the $7 B in cash to be caught and the people in charge fired without pension. We need to get rid of parts of the Health Care bill that big companies are opting out of because of paid for influence; no one else should have to pay if they do not. We need to tell those with “intellectual property” meaning US Patents in Bermuda to pay taxes on that transfer pricing or face forfeiture of patents and serious jail time. In short, if lack of money might bring this country down, stealing from it (like double billing for Medicare) needs to be treated like treason for a while.

2) The housing situation has to be addressed. We have acknowledged that the area is a disaster, and have bailed out “some” of those involved, meaning banks and various other holders of mortgage paper. Somehow we have forgotten the homeowner, and the carnage to other owners of cascading downward prices caused by ineffective renegotiation of home loans. We could save countless home owners by just giving them the current market price for mortgages, making them go through the appraisal process and get a “new” loan in this environment is insane. For instance, if someone bought a home for $250,000, put 20% down, and has a 6% mortgage, the payment is now $1,199. That house is probably now worth $165,000, depending on the area, so the idea of a new loan for the $200,000 outstanding is not going to happen. With current market price on loans, 4.25%, that payment, if the person is willing to stay, on the original $200,000 would now be $963. That $235 per month would save a huge percentage of homeowners, with no write down on principal. It also would help the person next door who now has short sales entering the appraisal process.

3) Pensions at all levels need to be addressed. Every person who has gamed the system, meaning the overtime their last year, sick days piled on, whatever, has to have that pension re-evaluated and brought down to the “intended” levels. Where is it written that if you scam the system once, the “system” owes you for life? Maybe we should address payback in some of the more egregious cases. I have talked on the air, for instance, about some teachers that have scammed the system. In every case I get calls and emails about that is only a few, and the great majority are abiding by the original intent of the formulas. I am sure that is true, but why is it my problem? It is yours to fix, don’t give me the examples to cite of people never making a salary of more than $80,000 a year, yet have pensions over that. You should fix it, so you do not have to defend it. It is your problem, and if you do not fix it others will have to. The thought of others, like those in politics, having a job for a few months (like County Board President Bobby Steele) and paid handsomely for life is repulsive, not to mention we can’t afford it. It is no longer a joke, it is gaming the system to the point of stealing. The military is not exempt from this review. A Captain does not need a full pension with full health at age 45, he can continue to work somewhere in the government until regular retirement age or get his pension reduced when he gets another job.

4) We need an energy policy. This is insane; all we do is talk about it as everyone in Washington gets the checks from the oil companies. We have abundant natural gas, yet not even the Federal government will commit to convert its vehicles to using natural gas as a fuel. We have windmills going up, but no commitment or plan to upgrade the grid so they can come on line. We could electrify some train lines, no commitment. In short, nothing. Energy reform could be the driver that sets the nation going for the next several decades. If our energy situation were first in the world, and cheapest, factories would be influenced to come back here strong. Weather proofing homes, passive solar technology, and active solar, does anyone care about any of this? Just get the check from oil and everything is ok?

5) Regulation. You can’t be a country where for every person working you have another writing procedures, two watching, one inspecting, and two evaluating. We know what fraud is, we know what stealing is, we do not need an army or people making you write procedures on how not to steal when you go to the grocery store, just a little enforcement when needed and penalties that make you pause.

6) Multinational corporations. They have to be governed by someone and pay somewhere; they can’t be the most powerful forces on earth and buy every government everywhere. Those that think that these companies should be sacred or be above governments, think again. Enough said.

I know that covers a lot, but it is really pretty simple. We have lost our way to a certain extent (in my opinion) but it is not too late.

How to trade? Pretty tough. We are in a relatively good situation in that virtually all of the assets we manage at PTI Securities, such as in the Protected Index Program (PIP), are covered by some type of put protection. That means we have assets to deploy when the time comes, but picking that time is still not easy. There is significant volatility edge in some of the calendar spreads and some very tempting covered writes, but being early when markets are moving a percent or more per day makes being early very costly.  So the good news is that we have money to deploy and minimal losses, it still means that I want to find the exact right day. I think we need to be short these bonds right now, as I can’t see rates going much lower, and some stocks here are getting down to levels where some covered straddle writes are looking attractive. It is our time to make some money, which is why we are protected. When everyone else is in a panic we are not. Let’ all have a good week.