Today the S&P VIX is sub-17. This level of complacency usually signals that we are topping out or at least due for a correction. Rather than short individual equities, at these levels I find the idea of buying Feb VIX calls (struck in high teens/low 20s) to be a very interesting one. This is not even a bearish call and doesn't require bearish thinking. It should be a prop-bet or hedge and nothing more. It's always important when buying volatility to give yourself ample time. While Bernanke continues to monetize our debt with daily POMOs under QE2 and suggests on 60 minutes that QE3 is a possibility, this market could stay at these lofty levels for longer than a person could fundamentally believe possible (...it already has!) Several months should provide ample time despite the higher costs. Also it is worth noting that options buyers of VIX calls/puts realize that by definition volatility tends to spike higher/lower in short periods of time. Therefore, one must be nimble if considering this idea. The premium, unless very near its maturity date, will be less than the actual in-the-money amount. For example, if buying Feb 20's at 3.00, and the VIX goes to 27, the option is not likely to be worth 7 (as expected) but more likely 5.50 or 6. This is because VIX tends to snap up and come back down almost as quickly.
Other indications that market participants have become too complacent:
1. In the last three months alone, insiders have sold just under $10B worth of their own stock. (Tyler Durden at Zero Hedge.)
2. Valuations of NASDAQ darlings such as AAPL, NFLX, AMZN, OPEN, BIDU, etc are trading at shockling high forward multiples. This is very reminiscent of the low-rate manipulated market that led to the tech bubble in the early 2000s. The marginal buyer here is almost certainly playing a dangerous game of hot potato and is likely only piling in at this point as an inflation hedge and because of some hubristic belief that they will be the first out when Bernanke and Co can no longer successfully prop up the market. If this segment of the market turns sour, it will do so rapidly as there are far more 'renters' than 'buyers' in these names.
3. The Eurozone debt crisis is far from over. The media does an almost fascinating job of avoiding discussing this theme until something dramatic enough happens that it must be reported on. In the days between pronouncements from Merkel, or bond restructurings, the media is happy to behave as though the entire debacle has suddenly disappeared. I assure you, it has not. While I do not personally believe the European Sovereign Debt Crisis will play out in the coming weeks or even months, its very existence will continue to trouble markets for years into the future, which should at least make marginal buyers at these levels nervous about playing the role of the greatest fool...
4. Ditto for tensions on the Korean Peninsula. From headlines suggesting war is imminent to narry a mention the following day, it is almost amazing to witness a) how short-term oriented we've become as a society and as an investor class, and b) how effective the media is at setting the agenda. What is frightening is that the situation in Korea is not developing in a vacuum. With the US engaged in what many central bankers have dubbed a currency war, the price of food in China spiking higher as a result, the US monetizing debt and devaluing China's dollar holdings in the process, one must at least acknowledge that a proxy war between China backed NK, and US backed SK is not an impossibility. It may be mutually destructive and may be outside of the realm of current thinking, but WWI and WWII were economically motivated conflagrations that seemed to escalate rapidly after a tipping point incident that alone shouldn't have caused so much destruction, let alone worldwide participation. Follow the bonds...
5. Margin compression will occur sometime in the near future. If inflation should begin to pick up meaningfully (which it already has) then input costs will also trend higher. Not all of these costs can be materially passed through. Demand for certain goods is relatively inelastic, but clothes retailers, boat makers, household appliance makers, etc will not be able to pass on higher input costs to consumers who have seen their incomes, job security, and net worth all deteriorate. Without wage inflation, it is unlikely that we will see much successful pass-through pricing without a reduction in the top-line. Therefore margin assumptions must begin to be revised downwards.
6. On the topic of demand and inflation, one must consider that higher food and fuel prices will restrict the amount of disposable income that the American consumer has available for more fully priced goods and services. A reduction in the top line is therefore imminent for discretionary service providers and goods manufacturers. The Federal Reserve's goal of propping up the stock market to create a 'wealth effect' is providing an opportunity for insiders to sell and giving officials more time to work out potential solutions, but it certainly is not trickling-down to the majority of American workers, most of whom have very limited equity ownership, and who view a higher stock market not as a sign of a recovering economy but as endemic of a kleptocracy making off with what's left before the whole thing comes crashing down.
There is a notable rise in the 'end the Fed' rhetoric lately and one need look no further than the growing Tea Party movement, the appointment of Ron Paul to head the Fed oversight committee, etc. The political turmoil in this country is not, in my opininon, rooted in foreign policy ideology, or family values issues, but instead mainly represents a class struggle. Somehow the Democratic Party has been colored as the political arm of 'nothern elitists' now seen by populists everywhere as being detrimental to the quality of life of the people in this country. Meanwhile, deficit-hawk Republicans get elected to 'rein in spending' who intern immediately move to deny unemployment insurance extensions to our nations involuntarily unemployed if they are not granted extensions to $600B tax cuts for the nation's wealthy. Really? Is the country too naive or disinterested to even consider how bizzare and hypocrtical that this is? If this Democratic administration had the guts people previously assumed that it did, why not push to end the tax cuts (and the Reaganomics obsession along with it) and redirect this money to at least a less inflationary way to directly create jobs via subsidies and invesment in new secular growth industries such as electric cars, the smart grid, wind and solar, nuclear power plants, rebuilding the nation's infrastructure, etc, etc, etc. Instead our nation's 'populists' decry this idea as 'fascist' or 'socialist' and instead prefer that we provide a shadow subsidy to our wealthy through unaffordable tax cuts and daily POMO operations. Are you kidding me? This will not end quietly. It may not be the coming of another civil war, but the political discourse surely is hotter than its ever been during a period when the equity market was bounding higher and higher.
7. The ability for the US Treasury to sell bonds at record low rates while monetizing our debt will not last forever. At some point foreign buyers will refuse to participate and the pricing will have to work higher unless you believe the Fed and the Primary Dealers can take down every issue from here to eternity. Any material rise in rates will certainly constrain real economic activity and our ability to return to reasonable employment levels and capacity utilization will be pushed out that much further.
8. There has been no real effort to reform HFT market manipulation. In fact, Getco, a leading HFT, was tasked as head market maker on the GM IPO. Wow. I knew it must have been substantial, but with this decision its now guaranteed that HFT lobbying efforts must be some of the most amazingly robust (and well-funded) of any such efforts on Capitol Hill. HFTs, along with the PDs, and the Fed, continue to make the stock market an unsuitable place for retail investors to invest. People are not as oblivious to ramp jobs, and stick saves, and bizarre low volume sell-offs/ramps as TPTB would like to believe. There is a reason that retail money has been steadily streaming out of the market, and that reason is that people don't like to play a game that they know is rigged against them. The flash crash was also a lesson on just how dramatically and rapidly markets can change when volume is dominated by algo traders and fast money institutions and not honest investors seeking to allocate capital to high EVA or ROIC generating businesses. Unless we see meaningful regulation and increased transparency regarding HFT, algo trading, dark pools, etc then those wise enough to have amassed investible wealth, will also be wise enough to avoid throwing it away in a casino.
I could go on and on, but to summarize, the incredible amount of both serious and pervasive issues confronting this market are, for at least the intermediate term, here to stay. It would behoove those with the wisdom to be intellectually honest to avoid being the marginal buyer in any stock which has risen 30%+ in a few short weeks. If you insist on staying on for the ride, at least take the opportunity to hedge yourself when volatility gets this cheap by purchasing longer-dated VIX calls at reasonable strike prices. Willing to discuss hedgining instruments off-line with anyone interested.
Disclosure & Disclaimer: This post should be taken as the opinion of the author only and is in no way a recommendation to buy or sell any security. The author may be long or short volatility at any given time without notice.
wow...bravo. Enjoyed reading this. I particularly agree with #'s 5 & 6. Do you think "inflation" can occur without meaningful wage inflation? 2007 showed us that commodity inflation is at least as much of a currency phenomenon as a demand phenomenon. I'm with you on that. Since labor costs represent an average of 70% of American firms' costs, it seems unlikely that consumer prices (apart from the input component) will increase materially in a world where U6 is 17%. And since the Fed looks at core PCE, Hoenig will just keep banging his head into the wall. Broad money is finally expanding (in the US at least). The most rapid steepening has been in the 2-5 year maturities. What will be inflection point for inflation, and when?
ReplyDeleteNoticed the crude strip finally switched to backwardation if only just barely, on hedging by producers. Will this signal a pause in crude's rise, with long players less inclined to hold inventory? Or is oil just following the $ and we should all convert our bank accounts to riyals?