Daily Update
Tuesday, December 6th, 2011
The market has traded within a very narrow range throughout the session and there is a definitive skew towards quality names as the gains in the large cap Dow Jones is outpacing the S&P500 and Russell 2000 by a 2 x1 and 3 x1 margin respectfully.
It has been a lackluster session as not many traders are willing to put money on the line ahead of the EU meetings coming up on the 9th of December which many view as crucial in setting the tone for the market going forward.
Implied volatility has pushed lower but not quite low enough to get long only mutual fund players excited about the prospects for the market and for short term players, implied volatility is perhaps a tad cheap considering the risks ahead over the next few days.
I have been running several trade scans and we have been close to alerting on several trades over the past couple of sessions as we negotiate the 200 day moving average. The market wants to push higher but until we prove that there is some degree of sustainable interest in the market at these levels (200 day ma) and at this junction in the year, we have to trade based on the fact that we are at the top of the recent trading range, no more no less.
So bottomline, we want to be bullish as that seems to be the most logical path here but the fact remains that there has not been any sustainable pick up in volume and general participation just yet which is something that makes us vulnerable to a sharp drop or sharp spike at any point on any slight headline.
A close above the 200 day MA would be a first step as would a pick up in volume into any strength. So far we have not had either.
Wednesday, December 7th, 2011
Markets are playing the wait and see game and traders are taking sides on the outcome of Friday’s European summit. I seems to me that U.S. equity traders may be overly optimistic on what the potential outcome of this summit could be. The German DAX has traded lower over the past few sessions and the European markets and market participants seem to be a bit more “grounded” in their expectations.
Back in the early summer of 2009, I told subscribers that the Fed had shown its cards and that the policy of easy money was one that could not be traded against. The Fed took the position of lender of last resort which has been the catalyst for the market rally from the lows of March 2009.
The ECB has yet to take the same position. This is due to many factors whose merits could be debated until the cows come home but the fact is that they (ECB) have been staunchly opposed to lowering rates under the leadership of Trichet and it remains to be seen if Mario Draggi, the new head of the European central Bank, is willing to take a more dovish approach and allow the Euro to depreciate which is what we would expect to happen should they lower rates (print Euros).
If and when this happens, we could very well expect the market to take another substantial leg higher. The issue is that they may not take the necessary steps to make this happen. Just as the decisions of the Fed here at home had its share of winners and losers, so would it in Europe. The Germans would certainly prefer to remedy the situation with austerity and keep the euro strong. The Greeks and Portuguese and so forth would certainly welcome a weaker currency.
Now the question we have to ask is which side has the most influence on what happens next and the answer here is that German do. The Germans by design made the ECB weak in their mandate to control the purse strings in Europe. They have been the biggest beneficiary of the Euro to this point and I am not sure they see value in taking the measures necessary to right the ship in Europe.
They have beeen at the “sweet spot” over the past 10 years and have been the biggest beneficiary of the European common currency. They, as producers of goods, have enjoyed the benefits of selling their products to the more consumer driven economies of southern Europe while maintaining a high standard of living for the more thrifty German citizendry. This “game” has come to an end because the southern nations are drowning in debt and the market has said “no more” much like when a person reaches their credit limit and lenders shut down their credit lines. Germany is going to have to decide whether or not to save the European union and the longer it waits to decide, the longer we will be in this “limbo”.
If we get a major shift in this scenario and the ECB adopts easier monetary policies, we will see a very powerful rally in Global equity markets. If not we may be a step closer to the worst case scenario for the market which is the demise of the European financial union and the Euro.
We opened a position on the GLD. The position is a bearish call credit spread and the way I see it, if the market does rally, I do see a slight pull back in the GLD as many will look to pick up stocks instead. If the market pushes lower, money would very well flood the U.S. Treasury bond market as Gold has not really been a “safe haven” during this crisis. In this case I would also expect gold to hang around these general levels. The position breaks even at 171.46 and max profit at our short strike at 164.00.
The technical argument shows the development of a wedge which should resolve to the upside but this will more than likely come later in 2012 as there is still some work to be done at these levels. Again this position calls for a move in the GLD perhaps down to 160 or slightly lower to the 200 day moving average.
Daily Update
Thursday, December 8th, 2011
We have structured a couple of trades over the past 2 days. Today we sold to close the final portion of the 124 Dec puts on our original butterfly position. The stand alone, December expiration, out of the money put option was on my radar to close today no matter what as it was vulnerable to both steep time decay as we near the weekend and also to a possible move against it after tomorrow. We also structured a new bearish leaning ratio on the SPY which I think will allow us to capture both volatility skew and decay over the next 8 days. The new position is a ratio (2 x 3) Dec 11 127 short call to a Jan 12 124 long call. The position offers us the opportunity to profit should we trade lower over the next 8 days to expiration as well as to profit if we trade higher over that same period up to the break even which is at 130.67 on the SPY at expiration 8 days from today. The best case scenario for this trade is for us to trade between 125 and 128 as we near expiration or if we trade much lower below 115.
The IWM trade is a January expiration bullish position which will do well if the outcome of the the current round of meetings in Europe has an immediate positive impact on global markets. If this is the outcome then we could possible push much higher into year end. This is, in my opinion, not a very probable outcome tomorrow. I believe we will rally into year end but that this will be a later December event to come after expiration next Friday. I think the probability that the European leaders disappoint the market is the most likely scenario tomorrow and choppy trading into next week. Nonetheless I do expect some money to be put to work as we wrap up the month.
The GLD position as I mentioned yesterday is a play that should allow us to profit on a move slightly lower in Gold over the next couple of weeks. The play has a directional and a decay component currently working in our favor. I think we may trade into the low 160’s over the next few days and weeks no matter how we trade in the equity market. On a bad tape, I expect funds to move into US Treasury and on a very good tape, I expect Gold to lag substantially as money flows to equities.
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Daily Update
Friday, December 9th, 2011
The Euro summit, which has had markets in knots over the past several weeks, has supplied the market with some respite from the immediate implosion of the Euro but little in regards to answers to the real dillemas facing Europe .ie too much debt. The proposed oversite of budgets and more stringent rules regarding spending are a positive for the future stability of the Eurozone but what is to be done with the problem at hand which is a tremendous amount of current debt which needs to be rolled and refinanced. Somewhat like someone in great financial stress who has overspent on credit who now pledges to cut up the credit cards and live within their means. The fact that you are going to adopt a more austere lifestyle is good for your future solvency but it does not pay the current bills…
In the end, what is needed to recapitalize banks and fund stability funds etc is the printing of Euros (devaluing the currency) which as I mentioned yesterday isn’t what is in the best interest of Germany so this is unlikely to happen anytime very soon. In the meantime what we get is more band aids and a unwillingness to tackle the issues at the core. Too many diverging political and national interests which makes resolving this a monumentous task at best.
So with a wobbly punt don the field, the politicians may have just managed to provide some cover until we start talking about this gain in early 2012. This is not done and something that we will have to deal with for some time with periods of ebbs and flows much like an ailment which goes away for a while and then flares up all of a sudden.
So what is the market telling us today? The VIX is down substantially and implied volatility is imploding. As the immediate risk is taken off the table, the skews between front month and back month implied volatility is narrowing quite strongly. This drop in implied volatility may be the first signs that a rally may be on the way. Seasonality is important here and as I have mentioned, money managers are underinvested and need to put capital to work. This is an important point to consider. Many of you may not know that Mutual Funds and other regulated investment companies can only hold a certain amount of uninvested cash in the portfolio. The amount or percentage of the fund which can be held in riskless assets is specified in the funds prospectus and obviously this differs from fund to fund, but bottomline, they have to put cash to work in whatever segment of the market that the fund invests in. The most underinvested funds today are the small cap funds and I do expect the small caps to outperform over the next few weeks if indeed we rally. The large caps in turn have outperformed and I think will underperform the small caps in this same period. Many large cap managers have been able to buy quality names on dips and aren’t as underinvested as their small cap peers.
Hedge Funds on the other hand don’t have the same restrictions as they are not regulated as Mutual Funds are. The idea is that many hedge funds have underperformed the indices or benchmarks and because of such, need to generate alpha. However we slice it, it seems that a rally may be in the works.
What are our pitfalls and road blocks? The ratings agencies may take a look at the outcome of this summit and decide to downgrade the sovereign debt of Europe. Here is my take on this. The market today is telling us that this risk may be already priced in. The drop in the VIX today along with market breadth etc is a real indication that there is substantial “dehedging” going on and that if we get a move down on a downgrade, it will be a short term buying opportunity and we will trade right up again.
I would caution everyone not to be too short the market going into year end after today. Although there is always the possibility for a swoon lower on any headline, there may be substantial short covering ahead pushing markets higher. Implied vol should continue to plunge into next week which will add fuel to the fire.
Do I believe that anything has been resolved with what has come out of Europe today? Absolutely not. We will still have to deal with this mess for some time to come but for the next few weeks we may have a chance to actually look at other factors besides Europe.
C.J. Mendes
cjm
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