More Extremes

Dr Melissa Reeves: Why do you call Billy 'The Extreme?'
Dustin 'Dusty' Davis: Because Bill IS 'The Extreme!'
--Twister

More data points suggest that we're approaching noteworthy market extremes. Bank of America's (BAC) fund manager survey is touching crisis-level sentiment in both expectations for economic growth...

...and for profit growth.

On a separate front, credit default swaps on investment grade (IG) debt widening--approaching levels that have historically caused the Fed to pivot away from program intended to tighten monetary conditions.

I continue to sense that, although the Fed is talking tough, it will act far more dovishly than currently expected.

position in BAC

Banking Options

So true
Funny how it seems
Always in time
Bet never in line for dreams
--Spandau Ballet

Major indexes put in their worst week since last October. Among the weakest sectors has been the financials. The bank index (BKX) has broken its uptrend from last fall.

Inspired by a couple of recent Stan Druckenmiller interviews, I have been thinking about what a modest short portfolio might look like to hedge against my investment longs. I concluded that a modest group of options (some in indexes and some in individual names) might be prudent for my taxable account in this environment. 

The financial sector seemed like a good sector for an initial project. Huge run up. Vulnerable in 'risk off' environments. Interesting characteristics of price movement in sector indexes (low short term volatility, but potentially high long term volatility). So I initiated a small put option position in the financial sector SPDR (XLF). Although I have a fair amount of option experience, it's been a while. Wanted to see how it felt.

Trading options is much easier these days. Narrower bid/ask. Much lower commissions. Can see why options have become so popular. Can also see why many folks quickly get into lots of trouble. Derivatives constitute another form of leverage. Gains are magnified, but so are losses.

Used in moderation, however, options can be a tool for managing some of the risk associated with a long-term stock portfolio. So far, feels like a good tool for me to use in this environment.

position in XLF

Letting It Fly

Time keeps on slippin,' slippin,' slippin'
Into the future
--Steve Miller

The always insightful Stan Druckenmiller zooms with the USC student investment fund group. In the first 20 minutes he offers prepared remarks, primarily concerning his current macro view, while the remainder is Q&A.

Druck lets it fly in part one. After unprecedented monetary and fiscal intervention in response to CV19 last spring, he contends that both the federal government and the Fed are being reckless on a historic scale by continuing to pump stimulus into the system after indicators show that the economy no longer needs assistance. Debt has exploded and prices are rising. He is preparing his family trust fund (a few $billion large) for Big Inflation with bets against the US dollar and on commodities. 

Although he remains long stocks, Druck says that he'll be surprised if he isn't out of equities before year end. I'm not sure whether he thinks inflation will hurt stocks or whether he believes prices are too high (he mentioned that he sees bubbles in nearly all assets classes).

Several interesting notes from the Q&A. On lessons learned from his mentors, Druck highlighted the advice he received about envisioning what things will look like in 1-2 years rather than where things are today. Today has already been priced in. Also enjoyed the Soros story about sizing positionss accordingly. Attractive opportunities should be well funded.

Re digital currencies, he suspects that the dollar et al will be headed electronic. However, he isn't keen on Bitcoin or its brethren being the chosen one.

On unequal wealth distribution, Druck suggests there has been no greater facilitator than central banks--a point these pages has made before.

In prepping for inflation, was surprised there were no questions or comments on gold. I'll take that as a bullish contrarian indicator...

His remarks on shorting also surprised me. While the last 10-12 years have been 'miserable' on the short side, Druck said that recently his shorts have been doing better than his longs. Moreover, given the historic macro situation, he suspects that upcoming years may be very friendly to shorting assets that are wildly overpriced. 

This inspired me to start thinking about setting aside modest short side space in my taxable account for some put projects. Also set up a short candidate watch list. 

position in gold 

Widespread MM Ignorance

"They've got all these fancy names for trillions of dollars of credit: CMOs, CDOs, SIVs, ABSs. I honestly think there's maybe only 75 people in the world who know what they are."
--Gordon Gekko (Wall Street: Money Never Sleeps)

The guy who wrote this previously worked for Treasury and the Fed and, by many accounts, was central to the design of modern repo and money markets (MM). He theorizes that money markets are headed toward a year end crack up that will require the Fed to begin buying longer dated Treasuries ('coupons) once again in a more traditional QE arrangement.

The complexity of the process that he describes gives one the sense that very few high level execs at the G-SIBs (Globally Systematically Important Banks), and the regulators that oversee these markets, currently comprehend what is going on in the MM plumbing underneath their feet.

Feeling some deja vu, as I got a similar sense of widespread ignorance w.r.t. mortgage-backed securities and credit default swaps back in 07-08...

Rate Cuts at Market Highs

'Cause she's so high
High above me
She's so lovely
--Tal Bachman

Major US equity indexes are marking all time highs after Fed chair Jerome Powell's dovish speech in front of Congress yesterday seemed to guarantee that the FOMC will cut rates at its upcoming July meeting. That the Fed plans to lower interest rates with markets at all time highs has raised more than a few eyebrows.

But such a move is not unprecedented. In the fall of 2007 the Fed cut rates three times to bring down the Fed Funds Rate a full percent from 5.25% to to 4.25%. Stock markets proceeded to rally to all time highs during this period.

The euphoria was short-lived, of course. The following year saw markets absorbing the full effects of the credit crisis. The SPX would fall more than 50% from those rate cut highs. In fact, the Fed furiously cut rates in 2008, lowering the Fed Funds all the way down to an astonishing 0.25% by December.

By that time, markets  no longer celebrated the cuts. Instead, they plummeted lower.

History suggests that caution, not euphoria, is sometimes warranted when the Fed cuts rates at all time stock market highs.

Gamma Trap

"Well, gentlemen, the players may have changed but the game remains the same, and the name of that game is 'Let's make a deal.'"
--Jack Trainer (Working Girl)

Interesting article in WSJ (discussion here) seeking to explain why we often get long periods of low volatility punctuated by sharp selloffs. The theory centers around the use of derivative-centered products that investors are purchasing to squeeze out extra income in a yield-starved world, and the hedging that dealers who take the other side of this trade must do.

Over the past several years, conditions of financial repression have found investors reaching for yield in increasingly exotic, and risky, ways. One way is to sell out-of-the-money puts. To sell (or short) a put, an investor borrows the option from a dealer, sells it, and collects the cash proceeds from the sale. As long as the stock does not decline to the point where the strike price is hit on option expiration day, then the investor happily keeps the cash income.

This strategy has exploded in popularity as suggested by the greater than ten fold increase in SPX option activity since 2011.

The dealer who borrows the put for the client to short is now long a put option or its equivalent in stock. Unless the dealer wants to keep a directional bet on its books, then it must go long some stock to hedge.

However, this hedging is not a one-time thing.

A characteristic of options is that someone who is long an option gets longer as the price of the underlying stock approaches the strike price. In options speak, 'gamma,' or the rate of change in the price of the option, goes up as the underlying price approaches the strike. As such, dealers who are counterparties in the above short option trade must continually hedge as stock prices change.

Because dealers are long put options in the trade, an unanticipated decline in stock prices suddenly finds extra gamma on the hedge book that dealers generally don't want. To offset the gain in gamma, dealers buy stock or futures to compensate.

As put selling strategies have increased in popularity (see above chart), the effect on markets is to put a bid under stock prices whenever they suddenly decline, thereby suppressing volatility and, perhaps, lulling investors into a false sense of security.

The graph above indicates the effect. The longer the gamma, the more dealers hedge. The more dealers hedge, the lower the range in daily returns. This is sometimes call 'volatility suppression.'

Seems like nirvana, doesn't it? The more market participants short out-of-the-money puts, the more income they get--with seemingly downside protection provided by their dealer counterparties against price declines.

Sensing as you might that there is no such thing as a free lunch, what could go wrong? One possibility is that dealers could get bearish and keep downside gamma on the books rather than hedge it by purchasing stock, thereby removing the underlying bid in a weak tape.

Another possibility is that stock prices gap down to the point where those who are short puts unwind their trades before they go too far awry. They will be tempted to do so because there are few faster roads to ruin than to be short puts in a declining market. Dealers would then work in reverse, short stock to manage gamma on their hedge books.

Market participants might also unwind their short option trade if interest rates rise and other income-producing opportunities reveal themselves.

Meanwhile, markets are coiling like a spring with increased leverage resulting from large derivative trades. The players may may look different, but we've seen this movie before and it does not end well.

Stability, when facilitated by intervention, leads to instability.

Hospital Insurance

"Well, I get darn sick of trying to pick up after a gang of fast-talking salesmen dumb enough to sell life insurance to a guy who sleeps in the same bed with four rattlesnakes."
--Barton Keyes (Double Indemnity)

Interesting article highlighting key developments in medicine and health insurance in the US. One development was hospital insurance. Early hospitals were designed for the very poor, particularly for those suffering from blindness, mental illness, or contagious diseases. Those who could afford better were treated at home or in privately run nursing facilities. Until antiseptic procedures were adopted, hospitals were key sources in spreading rather than curing diseases.

Because hospitals were perceived as places for the poor and desperate to die, demand and supply were low. In 1873, there were only 149 hospitals in the US. Things obviously changed over the next one hundred years. By the 1970s, the number of US hospitals had reached about 7,000.

From their beginning, hospitals had a financial problem. They are labor intensive and expensive to operate, with the majority of costs being fixed and independent of number of patients served. To help solve this problem, the idea of hospital insurance was born in the 1920s. The first hospital insurance plan was introduced at Baylor University Hospital in 1929. Some 1,500 teachers paid six dollars in annual premiums. In turn, the hospital agreed to provide up to 21 days of care to subscribers who needed it.

In exchange for the modest fee, subscribers were protected from unexpected health care costs while the hospital improved its cash flow. Before long, groups of hospitals were offering similar plans which gave subscribers choice of which hospitals to use. This became the model for Blue Cross which first operated in Sacramento, California in 1932.

These hospital plans differed from conventional notions of 'insurance.' Traditionally, insurance policies protected policyholders from large, unforeseeable losses and came with a deductible. In contrast, early hospital plans paid all costs up to a limit. The primary reason of course, was that the policies were being underwritten not by third party insurers but by operating hospitals themselves that were trying to generate steady demand for their services and regular cash flows.

The tradition of early hospital 'insurance' to cover health maintenance costs rather than catastrophic medical costs was one of three defects associated with these plans that would ultimately drive US healthcare costs through the roof. A second defect was that the early plans paid only those medical expenses incurred in hospitals. Consequently, those cases that could be treated on an outpatient basis were instead kept in house--a more expensive form of care.

The third defect was that hospital insurance did not provide indemnity coverage. Indemnification is when the insurer pays for the loss and then the policyholder decides how to best deal with it. Instead, the insurer (hospital) was providing service benefits, and paying the bill whatever the cost was. Consequently, consumers of medical services had little incentive to shop around. This raises the classic moral hazard problem--which someone else is paying the bill, healthcare consumers become indifferent to the cost of care.

Predictably, the medical profession lobbied in favor of retaining the Blue Cross system. The American Hospital Association and American Medical Association worked hard to exempt Blue Cross from regulation that would have forced it to adhere to standards required of more conventional insurance plans. Meanwhile, the IRS ruled that hospital insurance companies were charitable organizations and free from paying federal taxes. Free from regulation and tax burdens, Blue Cross and Blue Shield (a physician plan similar the Blue Cross hospital plan) came to dominate the market, holding about half of all policies outstanding by 1940. To compete, private insurers began modelling their policies similar to the Blue Cross and Blue Shield designs.

Hospitals thus came to be paid on a cost-plus basis, receiving the cost of services provided plus a percentage to cover costs of invested capital. Incentive for hospitals to be efficient vanished. Incentive to add capacity, on the other hand, escalated.

This led to an odd economic situation where price of health care rose despite many years of increasing medical supply. We'll pick it up from here in an upcoming post.

Where's the Leverage?

"And I hate to tell you this, but it's a bankrupt business model. It's systemic, it's malignant, and it's global...like cancer."
--Gordon Gekko (Wall Street: Money Never Sleeps)

In past bubbles, leverage was concentrated and easy to spot. In the late 1990s leverage clustered in dot.com. In the 2000s it accumulated in housing and mortgages.

This time around leverage is harder to recognize. Yet, derivative usage, corporate debt, duration, and sovereign debt are all at record levels.

It is tougher to see leverage when it is all around us.

Rather than being dormant and local, leverage and its associated risks have become malignant and systemic.

War Drumming Markets

"'War is a continuation of politics by other means.' Von Clausewitz."
--Captain Frank Ramsey (Crimson Tide)

Markets took a hit on Thurs on back of North Korea situation--although not as much as one might have expected. Muted downside market response marks the time we live in--although that could change quickly, of course. Currently the SPX is not quite down to support defined by the multi-month uptrend line.

Volatility indexes did seem to take an outsized jump compared to the move in stocks. VIX was up nearly 60% in two days.

I happened to look at put schedules mid-week before the jump in vols. Despite historically low index vol levels, out of the money index puts did not look cheap to me--certainly nowhere near 'Simon' levels. This suggests significant option 'skew,' and is consistent with market participants scooping quantities of downside 'insurance.'

Sitting on my hands for now, and will see how things unfold.

no positions

Overdependence on Insurance

If you change your mind
I'm the first in line
Honey I'm still free
Take a chance on me
--ABBA

Ryan McMaken argues that a primary way to improve the healthcare system is to reduce dependence on health insurance products. Use of insurance as a principal means of distributing healthcare is largely a post WWII phenomenon--borne from government tax and regulatory interventions that rewarded corporations for offering health insurance to employees. Subsequently, the insurance model replaced cash markets where consumers purchased healthcare goods and services for a fee.

As insurance replaced fee-for-service markets, healthcare costs began their ascent. Why? In large part because health insurance invites moral hazard and subsidizes consumption, thereby reducing incentives to shop for value.

Cash markets, on the other hand, encourage entrepreneurship among producers who must constantly become more productive in order to win the business of value-conscious buyers. Thus, as McMaken notes, we observe ongoing patterns of innovation in industries that rely on cash-for-service transactions. Food, for example, a cash market good that is no less essential for life than healthcare, constantly gets better and cheaper and now comprises a lower percentage of household budgets than in the past.

McMaken proposes changes to tax codes and regulations to reduce dependence on the health insurance model. Tax-free health savings accounts and tax credits for health spending should be expanded. Group coverage options beyond employer-sponsored plans should be nurtured. Markets need to be opened to more providers willing to operate in fee-based markets.

He makes a nice point near the end of his article. If a society wanted to build a healthcare system where prices were permanently high and improvement was hindered, then one would be hard-pressed to design a system more conducive to those outcomes than the current one.

Derivative Deja Vu

"Well, you can be wrong a million times. You only gotta be right once."
--Doug Carlin (Deja Vu)

On the back of yesterday's DB post, ponder this graphic:

Discussions about derivatives may soon become popular once again.

Pension Put Selling

They gave you life

And in return you gave them hell

As cold as ice

I hope we live to tell the tale

--Tears for Fears

A predictable consequence of eras of financial repression is that investors will seek out riskier sources of yield. Pension funds, for example, unable to earn large enough coupons from traditional fixed income vehicles, are now resorting to put selling to earn income. 

As long as prices stay elevated, then the 'free money' comes tumbling in. However, when prices fall, then risk becomes reality and losses mount as those who are short puts must cover at higher prices.

At some point, stretching too far for income in this environment will sever people from their capital.

Growing Complacency

I have become comfortably numb
--Pink Floyd

Stock market rallies invite complacency. Higher prices make money manager less prone to purchase downside protection. The price of that protection therefore falls.

Moreover, lower volatility can nudge managers into taking more risk thru use of leverage, creating a state of 'compression' w.r.t. volatility.

Currently vols suggest complacency is reaching noteworthy levels. Knowing full well that volatility indexes are not effective timing mechanisms, I bought some INTC puts this morning given the price discount.

position in INTC

Why Are Spreads Widening?

Once I rose above the noise and confusion
Just to get a glimpse beyond the illusion
--Kansas

Why are bank credit spreads blowing out? Unlike 2008, when the causes of widening spreads were a mile wide and easy to see (i.e., mortgage-related derivatives), this time around I'm having trouble pinpointing the cause.

One theory surrounds plummeting oil prices and the strain this places on junk-rated oil and gas operators (and their leveraged bank creditors). While certainly contributing to domestic bank woes, this theory does not satisfactorily explain the global nature of the credit spread wides.

Instead, I'm pondering a theory surrounding the growing implementation and impact of negative interest rates (NIRP), a central bank policy that once again caught limelight recently when the Bank of Japan suddenly went negative.

Essentially, NIRP imposes a tax on creditors and depositors. Depositors must pay banks for the privilege of placing their funds with the institution. All else equal, this will motivate depositors to deposit less or, worse yet, pull their deposits. No big deal perhaps when banks were simply money storage facilities. But today, banks are leveraged investment machines that pyramid deposits 10:1 or more. Can you say 'bank run?'

John Succo adds that NIRP also imposes costs on carry traders. In 'normal' times reducing interests from, say, 1% to zero, traders would borrow the low interest rate currency and sell it to finance investments in other countries. Selling the low interest rate currency causes it to weaken while pushing higher the currencies of countries receiving carry trade investments.

In a NIRP world, however, borrowers must pay a fee to hold proceeds on deposit, thereby reducing incentive to put on carry trades. Moreover, NIRP currencies are less likely to devalue when carry traders don't/can't sell them. Policymakers hoping that NIRP will cause currencies to devalue in beggar-thy-neighbor fashion are likely to have their hopes dashed.

As the world awakens to these NIRP realities, perhaps that is why bank credit spreads are blowing out.

Perhaps that is also why gold is on the move.

position in SPX, gold

Bank Credit Spreads

"It's clear as a bell to those who pay attention. The mother of all evil is speculation--leveraged debt. The bottom line: it's borrowing to the hilt. And I hate to tell you this, but it's a bankrupt business model. It won't work. It's systemic, malignant, and it's global...like cancer."
--Gordon Gekko (Wall Street: Money Never Sleeps)

Hard to ignore trends in credit default swap (CDS) and other derivative prices indicating investor concern about global financial institutions.

Acute in names like Duetsche (DB).

Definitely getting some '08 vuja de.

position in SPX

Unmarked Energy

Here I am in silence
Looking round without a clue
I find myself alone again
All alone with you
--Information Society

Many believe that the key to stemming the credit market meltdown in early 2009 was not TARP, ZIRP, QE or any other acronym spooned into the monetary policy alphabet soup. Instead, it was Fed-led efforts to suspend FASB market-to-market requirements which permitted banks et al to avoid accurately pricing illiquid, depreciated mortgage backed securities and other assets--thereby steering clear of having to report conditions of insolvency.

It appears that the Fed is at it again--this time in the energy patch. ZeroHedge reports that the Dallas Fed has quietly suspended requirements for its area banks to mark distressed energy sector bonds to market. As such, banks are not reporting impairments or writing down losses from investments in energy industry debt. Using Wells Fargo (WFC) as an example, it is easy to posit that banks are lugging hundreds of billions of energy sector junk bonds. It is also easy to postulate contagion potential.

Stated differently, banks are once again bailed out by the Fed for excessive risk taking. Last time around the theme was mortgage backed securities. This time around it is junk bonds linked to energy companies.

no positions

Of Fish and Bait

As sure as night is dark and day is light
I keep you on my mind both day and night
--Johnny Cash

With another 2% down morning, we're here at the Aug lows. Some technical support evident in the SPX 1850-1880 zone. After that, not much till 1700ish.

Note also the head-and-shoulders look...

Took some exposure off (INTC puts with stock down on an 8% whoosh). Will let other short exposure (SH, JPM puts) ride for now.

position in SH, JPM

Ominous

"Man looks in the abyss. There's nothing looking back at him. At that moment, man finds his character. And that is what keeps him out of the abyss."
--Lou Mannheim (Wall Street)

Ominous action today as a 400+ pt morning move higher in the Dow didn't stick, and domestic equity markets finished instead in the red, down about 1% and closing on the low tick.

The SPX closed today on yesterday's intraday lows, suggesting that the index is peering into a near term abyss.

Longer term perspective reveals that this selloff has brought us down to the uptrend line formed from the March 2009 lows. As such, a significant break lower from here that sticks would technically 'end' the uptrend.

In early afternoon I did decide to get involved with the banking complex, with JPM as my vehicle of choice.

position in SPX, JPM

All the King's Men

We
Are young but getting old before our time
We'll leave the TV and the radio behind
Don't you wonder what we'll find
Steppin' out tonight
--Joe Jackson

Approximately eight years ago to the day, I was in NYC visiting my good friends at Minyanville. Early tremors were shaking markets as subprime derivatives were beginning to fall apart.

I remember thinking two things. One was that few people in The City seemed aware of the danger ahead. Real estate was flying. $1000 dinner tabs were common. Limos filled the streets.

The other was that the Bush administration and Republicans were going to have their hands full trying to keep the markets together ahead of the 2008 election. They couldn't, of course, as the SPX sank by about 50% over the next year.

Here we are eight years later and the shoe is now on the other foot. Early tremors are once again shaking markets--although with less effect so far as the markets have been heavily medicated. The Obama administration and Democrats are surely thinking about what they can do to prop prices up for the next year.

One problem that they face is that they have already moved heaven and earth to jam markets higher for the past few years. As bad as they were, the Bush people applied nowhere near the preemptive interventionary force currently being administered by the Obama group.

The question is whether this administration has any interventionary capacity remaining. What tricks the Obama administration might still be able to pull to keep those limos cruising the NYC streets in the months ahead?

position in SPX

Subprime Education

Professor Jerry Hathaway: When you first started at Pacific Tech you were well on your way to becoming another Einstein and then you know what happened?
Chris Knight: I got a haircut?
--Real Genius

College students would stand better informed if they heard this 'commencement speech' by George Will. Preferably years before commencement, of course. High school, even junior high, would not be too early.



While the previous real estate bubble created the subprime mortgage, the current higher ed bubble has created the subprime education.

Superb analogy.