Nov 28 Stock Market Observer 2010-11-28

The past two weeks has been a more interesting time in the markets than we have seen in a few months.  With all this going on and since we just passed an options expiration and have redeployed into a new set of options contracts for our clients, an update is in order.

Quick History

Let's start by backing up a few months. Up through April, 2010 the market was headed up off the March 9, 2009 lows, shifting from modestly valued (on a fundamental basis) back to over-valued during this 68% climb. In April, 2010 government stimulus programs (like new home tax credits) ended.

The government threw a lot of money at the country's problems and patched the bleeding, but they did nothing to heal the wounds. As all of these programs wore off, we were cautious to see how the economy behaved (and the stock market as well). May (flash crash), June and July were volatile months. The VIX jumped as prices plummeted.

Quantitative Easing II

Things have shifted once again with Ben Bernanke's pledge of a second round of Quantitative Easing. This has not been a popular policy either abroad or here at home. The market has given up 5% in less than two weeks, but still volume is anemic - which tells us that there in little conviction in this move.

North Korea

On 11/22/2010, North Korea bombed an island in South Korea. That combined with worries about Ireland's banking system and sovereign debt issues made for a rough day in the markets on Tuesday. While the tension still exists today on the Korean peninsula, the market seems to no longer be bothered by events there.

Ireland

It would seem that the market favors the IMF / EU bailout of Ireland even though many economists (including me) only see this as a quick route to making things worse in the very near future (see Economic Observer - Ireland).

Fundamentals

On a fundamental basis, the market is still very pricey. We have tried every legitimate trick in the book to come up with favorable valuations for the US stock market, but going forward we don't see a lot of upside over the next four to ten years. Things could change (for example a sizable drop in the market would change these metrics) which means that next year, the prognosis might be better. But if we stay in this trading range or go higher in the next several months, the longer range chances for significant growth in equity prices would seem fairly slim.

This assumes we avoid another economic crisis in the next few years and that we don't experience any major shocks to the system - two possibilities that are all two likely (see Economic Observer), especially considering policy errors that seem to be hard-wired into our current political spectrum.

System Shocks

Between Korea, Ireland (with Portugal and Spain to follow) and the changeover to a new Congress in the United States at the turn of the year, there are a lot of potential shocks that could hit the markets and the economy. My guess is that the playbook will include a lot of "more of the same."  That would be increased volatility followed by some government bailout or other form of meddling to "save the day."

The markets will likely get spooked at some point and the roller coaster ride will continue to be more violent than most people like for awhile. There will also likely be periods like August & September where everything calms down for no apparent reason. Folks will get lulled to sleep feeling that the worst is over until something else comes along to shake the ride from it's foundation. In the end, I don't suspect folks who use "buy and hold" will find themselves in a much better position a few months from now, but may very well find themselves far worse off.

This is life on the Stock Market Roller Coaster of the 21st Century. If you insist on riding this ride, you better get used to it.

Bonds

Don't look to bonds to save you. We are at the end of a 30 year bull market in bonds as rates have fallen from the high teens in 1982 to near zero today. When rates go up (and they will - the one thing we can't tell is when), bond holders will get smacked. Moving from equities to bonds is like jumping from the frying pan into the fire.

The top for bonds may almost be in. Muni's gave up all their gains for the year in just two weeks and short-term corporate debt also is seeing signs of pressure.

Options Strategy

The options strategy we use was well suited for this environment of April-July of this year and it was easy to collect target premiums with lower-than-target risk. As we hit late summer, the volatility went away. Volume has been anemic (quite common in summer) as the latest rally started at the end of August. Prices climbed about 15% to their peak in early November. In this environment it has been very difficult to get a reasonable premium on the sale of an options contract without exposing client money to more risk than we would normally like.

By late morning on Tuesday (after the Korean missile event and the Ireland banking problem hit the tape) we were selling PUT options on the SPY with a strike price of $113 and collecting $0.89 per share or 0.78% return (pretty close to our target). The next day, the market bounced back up and options which we sold at $0.89 were all worth only $0.50.

We were lucky on the timing of this, but happy to finally find an option we could sell for target return without having to take on more risk than we want. This was a scenario we haven't seen in a few months.

Overall, the strategy has worked as we said it would the past six months - although the premiums have been lower than average the past three months due to lack of volatility in the markets. The important thing is that we have protected client accounts from the risk of the roller coaster ride. While 3% total gains (after all fees) in six months is less than we'd like to see, it does beat out no gains and a wild ride which is where the S&P 500 has gone since early April.

If you have any questions, please let me know.

FREE WORKSHOP: If you are interested in getting on the SLO ride to wealth (as opposed to the vomit comet of the stock market roller coaster), you are invited to attend the next free workshop on alternative investments. It will be at the ALTUS Wealth Solutions Learning Center in San Luis Obispo, CA on Tuesday, December 7 at 6pm. More details are at http://AltusWealth.com/Options.pdf.

All I ask is that anyone who wants to attend should call and reserve their space because seating is limited.