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You Can’t Be Half a Gangster

December 5, 2011


Good morning. It was a huge week for the market last week, with the SPY up 8.52 (7.3%) to close at 124.86. That number represents a gain of 2.3% over the last two weeks, and a decline of 1.4% from the close three weeks ago on 11/11. The VIX last week dropped a full 20% to 27.52, indicating strongly that the market perception of risk, at least in the short term, has dropped significantly. Why the sudden change in market attitude? It has dramatically to do with the coordinated action by governments and Central Banks undertaken last Wednesday to pour dollars into the European Banking System. That action brought to light a shift in focus from pressure on the European Central Bank and the governments of the more affluent countries in Europe (notablyGermanyandFrance) to more involvement by the International Monetary Fund (IMF). In other words, the needed “bail out funding” might now consist of loans from the IMF, either to the ECB or directly to the individual countries. For instance, the idea had been floated last weekend that the IMF would provideItalywith enough short-term financing to allow their “austerity” programs to gain traction before they had to go back to the market for financing, sort of a “bridge loan” between being profligate and austere (whatever that might mean).

Why is this latest scheme worth an almost 500 point up day (last Wednesday) and the VIX down 20%? Well, it appears that by using the IMF they (meaning Sec. Geithner) can finally find a way to directly use U.S. money for this European bailout (which lots lot of people here do not want to happen). TheU.S.is “nominally” 17.72 percent of the IMF, but I would find it hard to believe thatItaly, for instance, is going to come up with “their” 3.32% share to save themselves, orSpainwith their 1.69%. I guess the question would be, if we could find the time or place to ask Mr. Geithner, is what amount are we really sending, and how exactly does he get the authority to send it? While we are at it, we could also ask how many people might have been in on (or informed about) the announcement last Wednesday, and how many were allowed (or even encouraged) to use that information wisely. Was there a French Bank about to go under, and, if so, how much better did their books look only one day late? For most, any move made by the government (no matter how ignorant or short-term oriented) that results in a market moving up is a good thing, and very few tears are shed for those either positioned “short” or run over in a market making capacity. For me, however, that is a problem. I think giving certain people real solid information about impending market moving situations is amoral, and “saving” a Bank (if that is what happened) by essentially allowing them to position themselves (by buying various products from people without knowledge) ahead of the announcement is grounds for impeachment. In some people’s world, however, all is good: banks just got a little stronger and the market has rallied. Where is the foul, who really cares about the faceless uninformed that essentially “paid” for it? The problem is that it is so hard to be “just a little bit” amoral. Sort of like in the television series “Boardwalk Empire” when the young fellow hands Nucky the envelope and tells him “Nucky, you can’t be half a gangster.” Once you get Federal employees moving and committing monster amounts of the population’s money (seemingly with marginal authority to begin with), and choosing who is able to profit by it, you have a real short and very slippery slope to a very bad place (in my opinion).

The good news is that, despite the unprecedented amount of both monetary and fiscal stimulus applied, the economic numbers are starting to show a sustained steady (but slow) advance. The factory production numbers are advancing, private sector hiring is improving, and confidence is up. The argument can surely be made that given the amount of stimulus the growth is too slow, but the run up cannot be ignored and should be welcomed for sure. We will never know if any improvement can be self-sustaining until we see at least some improvement, and we are seeing it finally. I think the pace of growth can be easily negated by something as simple as a lack of extension of the payroll tax cut, but if you keep the cut in place I don’t see how the average household ever pays back the $1,000+ per month the government is borrowing on their behalf. There is no easy solution. Wait a minute, I have the solution, quickly flood the economy with money so in five years everyone’s debt is effectively cut in half, and asset prices double, and people have to pay taxes on capital gains that really aren’t gains at all. Ya, that’s it! Why didn’t I think of it sooner?

In light of the fact that we are finally starting to see some positive movement in the economic numbers, why can’t I just look in the mirror and say, “Self, why can’t you just look at the numbers, look at how it is playing out in the minds of our seemingly half armed leaders, and run with it?” The answer, after a lot of thought, is that I think we are getting to the tipping point, really in two separate areas that might come together with a big bang. The first is, and maybe the German fiasco bond auction of two weeks ago might be the first indicator, I think the market is very close to starting to exact a higher price for the rampant sovereign debt (US included) in the system. Next yearEurope’s Banks and governments (really the same thing if you think like Europeans think) have over $2T to refinance. The US needs, at current deficit levels, probably another $1.2T in just new financing to cover next years deficit, and add to that however much needs to be rolled over of our $14.6 current debt and however much the Banks may need. Not sure my calculator goes that high, but I think there is a solid chance the price to achieve that financing might go up. People can collectively seem to act fairly oddly at times (I did not say ignorantly, but look at some of the people we vote for), but even the most challenged among us is not going to (and did not at the recent longer- term German bond auction) give money to Germany at less than 2% when that money is being used to effectively “guarantee” Italian debt paying 6+%, the same thing we seem about to do. Why would you go for the 2% if it all were perceived to be part of the same “pot”? How does thatUSdeficit look at 6%, or 8%?

The second issue I am concerned about is the regular guy (and lady of course). I see who is winning here in this time of financial stress, and it is not he or she. Last week the employment numbers, through revisions, pointed to some improvement in the aggregate. However, the hourly earnings number was actually down (.1%) on the month. Down! We also had, mysteriously, over 300,000 people no longer in the labor force. I am going to guess that they are still alive someplace, just not collecting unemployment (I am sure some are employed somewhere in the underground economy, but surely not a majority). This is the same group that has seen housing values shrink by 40% or so but have had property taxes sink by only 1%. I would suspect that the same group, if covered at all, has seen their contribution to health care at work outstrip any raises that may have occurred. We could probably go on and list fees, state tax increases, etc. tolls, train fares, etc. all on the upswing, a lot being thrust on a younger population hopelessly buried by education debt. Next year we already have FDX, UPS, and many others initiating price increases, not a surprise at all given we have a Federal Reserve growing the money supply by 15+% and a Justice Department that has let industry after industry become an effective oligarchy. Through it all, the American citizen has been resilient (as evidenced by early Christmas buying numbers). My guess is, unless we start to see some real numbers go up on the income line (not really interested in the amount of jobs line, I want one job paying $30, not two paying $8) any significant increase in inflation will cause the average American to hit the wall. With no automatic COLA increases (except for public sector who will pay for it with even higher taxes making things worse) the average person will finally be put over the edge as those able to pass on price increases celebrate. I see this collision course (just like two outfielders going for the same ball on the softball field when you can see it coming but can’t stop it) very clearly, and fervently hope I will turn out to be wrong, or policy will change in time. One thing I feel sure of, that the furious tenacity shown by our leaders to save or help the few is really working against the many, but the feeling seems to be “So what?’

Having said all that, and wishing myself to be wrong (maybe an adult will show up and change policy in time), how do we trade it? Well, obviously you want to be long when the leaders decide to catch people short and move markets. The other thought is that we are still in a somewhat violently traded range, but maybe some cooling of the European situation (even with our money) might get us out of it to the upside. There is no doubt that the companies with pricing power will probably do well, and we have seen sustained rallies in the XLE, IBM, CAT, and others. We have seen some steady progress in our new “hedged” dividend program, as those stocks appear (for the time being anyway) to be out performing the general market a little. A consistent problem in committing new capital is in the price of the further out puts we use for protection. I would have loved to have been a buyer last week when the market was lower, but the price of the longer term puts we use for protection were fairly prohibitive, and even after this rally they have not dropped very much. Normally, in these situations, we would think about using a put spread instead of an outright put buy, but if something bad happens here on a world scale I am not sure only 15-20% protection is enough. I think if the market were to give us another chance we will consider some shorter-term call spreads to participate at least some in whatever the next trick the government throws out there. I really do think that failed German longer term bond auction was a signal to get rid of most of everyone’s longer term bond assets and maybe go short the bonds if we get any sort of rally from here.