Opportunity thinking
Posted: February 10th, 2009 | Author: Wayne Weddington | Filed under: Opinion | Tags: market meltdown, market volatility, Strategy, Volatility | 2 Comments »Most of the financial news outlets are posing the question: keep stocks or sell?
The opportunities transcend the binary choice of liquidating your portfolio or simply holding on for dear life. No doubt about it, the next twelve to eighteen months are going to be volatile. I think the general trend will be weakness but there will be flashes to the upside as well. A few months ago the Dow had a +9.0% day which was huge. I was impressed, only to find out that it was merely the sixth largest in history. The other five times occurred in the period 1929 – 1933, in the wake of the Great Depression.** So expect big down days and big up days occasionally. Volatility.
In Do-it-Yourself Hedge Funds I discuss opportunity thinking. In other words it is a way to take today’s news and turn it into actionable market opportunities. It is not a secret sauce but provides a starting point for your strategy objectives and implementation.
There are infinite possibilities that could yield desired results for the current year, but they will all likely derive from high volatility, and declining fundamentals, both economic and company-specific. For example, if you have a portfolio of blue chip stocks, selling volatility premiums against it is not a bad idea. The VIX has been hovering between 40 and 80 which allows the average investor to sell “volatility premiums” to the market. Yes, it could limit the upside, but if you look at the equity markets since October 2008, they have been trading a fairly tight range. Selling premia is a way to capture that vol as cash until there is a breakout either way.
You should also think of pairs trades, especially for individual securities versus their peers individually or the sector at large. For example one thing I noticed, going into the fourth quarter of last year, is that McDonald’s (MCD) and Walmart (WMT) performed relatively well for then year-to-date, despite the prevailing predictions of gloom and doom. Part of the reason is that these companies, while categorized as Consumer Discretionary companies, really trade like Consumer Staples in tough times. When dollars are tight, people go to McDonald’s and Walmart to stretch their dollars. Sad that MCD behaves as a Consumer Staples company. But true.
Rather than take a naked buy on these companies (even they are laying off and experiencing declining performance), a relative-value trade would have provided significantly more return and arguably less risk. A “pairs trade” of buying MCD and WMT while shorting the broad retail sector (such as XRT, the S&P Retail Sector ETF) generated a relatively stable return (>40%) in 4Q 2008. That may seem like 20/20 hindsight but, believe me, there were many hedge strategists in that trade and others that reduced full market exposure while taking advantage of relative performance. The narrative for this trade was derived from simple daily news.
I said in an earlier post that these markets require extraordinary measures. Yes, it would seem right now that the only thing better than money is cash. But also keep an eye out for the opportunities that manifest themselves by very virtue of the toxic mess into which we have gotten.
-Wayne Weddington
** I recalled these market stats from memory.. they may be approximate.
Small investors can be potent and effective contributors to financial markets as witnessed by the last presidential race funding source. Small twenty dollar contributions made a large difference so I encourage these types of movements on the stock exchange market. But I despise the industrial military complex as a investment portfolio to gain ROI. However the path to wealth building though hedge funding methodologies include a wide birth of investment protocols. So be it.
That raises a few issues that I would like to address.
The first is that the benefit of small investors is patent. The more market participants the better. Higher market participation, particularly informed market participants – results in informed pricing…. And each investor’s outcome will depend upon his risk preference (tolerance). A short-term short-seller and a long term investor need not have opposite returns.
For example, in trading the developed equity markets, the markets with higher participation tend to have truer pricing and less volatility. The US (SP500) and the UK (FTSE100) for example have broad capitalization weighted indices and a well-established futures market. The individual investor can get exposure to those markets through an equity future (denominated $60,000 and $75,000 respectively) or they can by an ETF for as little as $130 a share. That significantly increases market participation, as opposed to the German equity market, the DAX, where it is comprised of only 30 stocks and the largest 5 stocks represent as much as 70% of the market capitalization of the index. The DAX future is denominated in multiples of $300,000 for 1 future, outside of the reach of many individual investors. And it shows. The DAX is significantly more volatile intraday than the broad indices with significant market participation.
I have read articles lately suggesting that the individual investor is leaving the equity markets because of the increase in quantitative traders which are rumored to have increased the risk inherent in the market. That is nonsense. Those that are selling their words in newspapers forget that there is a reason for the bid/ask spread. It exists so that there is always liquidity to trade whether the investor is a grandmom in middle America or a seasoned trader in New York. The b/a spread exists specifically so that there is a trade to make…. And the exchanges compensate those who would make a market there with the spread. Depending upon the instrument it is between 1 and 2 basis points. On the contrary, the high speed traders are exploiting only that spread (and sometimes anomalous spreads to other “like” instruments…. the SPY versus the SP500 e-mini for example). There are no longer the anointed market makers from the old days before widely available computer trading and individual access. Nowadays the market makers are not anointed but they are compensated by the exchanges directly by making bids and offers to the market. It is like the 5-cent deposit made on plastic and glass bottles. These players make nickels and dimes and do it fairly at the market price, not some designated market maker who is favored by the exchange to do it. We should thank them. If there is a cost to the individual investor, I would argue that it is only the bid/ask and the investor should be grateful to pay it. It is the price of liquidity.
Lastly, I think it is unwise to let legislators figure out the markets. The markets have an innate intelligence which is far superior to the addled mind of the politician. Those who would be opposed to this view often suggest that the current economic situation is evidence that the markets cannot police themselves. Again, nonsense. The reason for the current market collapse is the result of a series of market bubbles – first the borrow and spending of the three Reagan/Bush Republican administrations, the Internet bubble/crash and the easy money that followed, the real estate bubble and then the bubble of the financial exotics as market players searched wild-eyed and imprudently for yield – and Fraud. And the cost of money was effectively zero.
But the markets did work. The housing bubble was based on fraud and greed. The market participants that would have failed as a result of this fraud should have been allowed to do so. Because those who take the risk with their own assets should be able to live or die on those decisions. The problem is that there were millions of people who did not sign up for the bubble b/s. The average American who had precious little savings in their checking and savings account had no idea that their “too big to fail” institutions were participating in this risky ruse were victimized by the fraud. But due to the erosion over time of the Glass Steagall Act, the institutions that were specifically intended to take conservative views in the market were some of the most egregious players. In a perfect world we would and should have allowed the private players to die off, in a Darwinian evolution of the best private investment players that navigate risk and reward….. except that governments, pension funds, endowments, retirement advisers etc – the protectors of the average persons’ portfolios – failed them by engaging in the same activity. The markets did not fail us, small investors were victims of a crime, the crime of privatizing gains and socializing the losses.
OK, this is last. I am torn on the reform of the tax code. The benefit of high taxes and large deductions is a powerful way to inspire investment and the efficient direction of capital by rewarding certain capital behavior. The flat tax is a popular mantra amongst the potential Republican presidential candidates, but there are things I like about the progressive tax. I have seen multi-billionaires claim that their tax rate is far less because they get great deductions. But what is lost there is that they earned those deductions as a result of tax policy. It means they may have made capital improvements to existing assets, donated money to a charitable organization, or yes purchased a plane for private air travel. One may not agree with all of the possible detailed deductions that the wealthy might take but it is a great way to efficiently allocate capital to causes without tying it up in the bureaucracy of government. What if a deduction were encouraged for a private citizen to sponsor a student of lesser means in parochial school? Or to adopt a local highway project or school refurbishment? By keeping the progressive tax and providing deductions for reasons that are useful to our society and to our communities, I think it is far better than providing a low flat tax and not knowing at all how those untaxed dollars would be spent. In the former case, while it may be true that the wealthy may have significantly reduced their gross tax burden, at least it would have been for reasons that we all agree could benefit the economy and the country.