Thursday, May 31, 2012

Put Selling as a Replacement For Stocks

The higher that market implied volatility becomes, the more attractive put selling (as a replacement to being long stocks) becomes.

The chart below outlines one such example, this being the put option payoff structure of March 16th, 2013 expiry puts on the ETF SPY. As implied volatility moves higher, the put premium (think of this as the insurance premium you are selling) moves higher (i.e. the payoff structure moves up).

In the example below, the current payoff over the next 10 months of an at the money put is almost 10%, which can be thought of as the "upside" should stocks stay at current levels or move higher, while downside moves in the same 1:1 fashion as owning the underlying SPY ETF (but you are cushioned by that 10%). If you want more cushion in the form of allowance for downside movement, you can sell further out-of-the-money puts (but collect a smaller premium).

A few months back, I outlined that implied volatility was so low that I was replacing some of my long positions with long call options (and short positions with long put options). If volatility moves higher, I will likely be doing the opposite and replacing these long call / put positions with short calls / puts.

Note: the payoff structure in the above chart should be moving down at a crisp 45 degree angle for all of the above put payoffs (the reason they don't is I am being lazy in the number of data points I used to create the chart).

First Quarter GDP Revised Down to 1.9%

Marketwatch details:

The U.S. economy ran into a deeper soft patch in the first quarter than initially estimated, a government report showed on Thursday.

The Commerce Department estimated that the economy grew at a 1.9% pace in the first quarter, slower than the 2.2% rate initially reported.

This is down from a 3.0% growth rate of real gross domestic product, the output of goods and services produced in the U.S., in the fourth quarter.

Source: BEA

Wednesday, May 30, 2012

What Happened to the Great Bond Sell-Off?

It's amazing that it was only a bit more than two months ago that I wrote this post defending bonds against what was labeled the "Bond Market Arab Spring". It's also amazing how wrong pundits continue to be as Long Treasuries have now caught up to the S&P 500 year-to-date after the ten year Treasury reached an all-time low.

Source: Yahoo

Tuesday, May 22, 2012

Existing Home Sales Rise Across the Board

While the overall level of existing home sales is still well below the bubble peak (4.62 million vs. 7+ million in mid-2005), the trend is positive across housing markets and prices.

Source: Realtor

Tuesday, May 15, 2012

(U.S.) Relative Strength

Despite the recent turmoil, unlike when I showed this chart last August (a time when the dollar was selling off and gold / commodities were roaring), the ETF's showing the least strength are all currency or real assets. I believe this accurately reflect the current (relative) strength of the U.S.

Checking in on Inflation

Marketwatch details:

Inflationary pressures are fading, just as Federal Reserve officials expected. But don’t think that the decline in the inflation rate will automatically lead to further quantitative easing by the Fed.

The consumer price index was flat in April, the Bureau of Labor Statistics reported Tuesday. And the CPI is expected to drop by at least 0.2% in May on account of the big drop in gasoline prices.

The CPI has increased 2.3% compared with a year ago, down from a 2.7% year-over-year rate in March and 3.9% last September. By May, the year-over-year rate could slow to 1.8%, below the Fed’s longer run target.
Looking into the details, there isn't much of a pattern, but it looks like most "stuff" we consume (clothes, food, medicine) increased in price at a faster pace than the headline figure, with the exception of alcohol (hence, I'm not complaining).

Source: BLS

Thursday, May 10, 2012

Trade Deficit Blow Out

Remember when we thought the U.S. was going to export our way back to prosperity riding European and emerging market aggregate demand (that wasn't a crazy statement even a year ago... promise)?

BusinessWeek details the reality:
The trade deficit widened more than forecast in March as American demand for crude oil, computers, automobiles and televisions propelled imports to a record.

The gap grew 14 percent to $51.8 billion, the Commerce Department reported in Washington today. The median estimate of economists surveyed by Bloomberg News called for an increase to $50 billion. A 5.2 percent jump in imports, the biggest in more than a year, swamped the 2.9 percent gain in exports, which also reached a record.
Change in Trade Balance - Chain-Weighted 2005 $$ (i.e. real change in 2005 dollar valuation)

With the re-emerging crisis in Europe since the March trade balance print (and what will likely be a resulting oversupply of goods coming from emerging Asia), don't expect this trend to slow any time soon.

Source: Census

Wednesday, May 9, 2012

Stocks for the Long Run?

While the below chart cherry picks one of the best performing fixed income sectors, it is still pretty amazing.

Bonds (defined in this example as the Barclays Capital Long Government / Credit index) have now outperformed stocks (defined as the S&P 500 index) going back to November 1980 (10.7% annualized vs. 10.4% annualized) and has more than doubled the performance of stocks over the past 15 years (239% vs. 108%). Note the chart below is total returns including reinvestment coupon payments and dividends.

Is this likely to continue?

Unless capitalism as we know it ends, the answer is a simple 'no' over the next 15 or 32 (or even 3-5) years. The government / credit index shown above yielded a whopping 13.18% as of November 1980 and the next 32 years were the great bond run that has resulted in the current paltry yield of 3.89% (just 7 bps off its all-time low).

Source: Barclays Capital / S&P

Monday, May 7, 2012

The Consumer is Back... Consumer Credit Positive (Even Excluding Student Loans)

SF Gate details:

Consumer borrowing in the U.S. surged in March by the most in more than a decade on growing demand for educational financing and autos.

Credit rose by $21.4 billion, the biggest gain since November 2001, to $2.54 trillion, Federal Reserve figures showed today in Washington. The advance was paced by a $16.2 billion jump in non-revolving debt, including student and car loans.

Americans may have been trying to get school financing before a possible increase in interest rates takes place on July 1. Rising consumer confidence also means that households are more willing to take on debt to boost spending, which accounts for about 70 percent of the economy.
I've been showing the below chart for some time. It shows the year-over-year change in revolving consumer credit, non-revolving consumer (excluding student loans), and student loans. Headline consumer credit has been growing since early last year, but this had been solely due to student loans (not necessarily a bad investment, but it doesn't reflect consumers re-leveraging for goods and services).

Well, as the chart shows, after a strong March where revolving consumer credit (i.e. credit cards) jumped 7.8% month over month and non-revolving (excluding student loans) posted a positive print... the day has arrived in which the consumer is no longer deleveraging in nominal terms (important for all that nominal debt out there).

We'll see if this continues, but the consumer looks like they may be back.

Friday, May 4, 2012

Ugliest Employment Chart You'll See?

Per Felix Salmon:

As Mike Konczal noted this morning, a key indicator of labor recession is still in force: if you’re unemployed, you’re still more likely to drop out of the labor force entirely than you are to find a job.
Let's see how that trend has fared over the longer term.

The chart below shows the ten year rolling change in the number of individuals employed divided by the ten year rolling change of those individuals no longer in the labor force. Any number over 1 means that the marginal person of working age is more likely to have gotten a job ten years later than to be out of the labor force.

In the late 1980's / mid 1990's, this marginal individual was a whopping 8x more likely to have found a job than no longer be looking. Today? 0.35x, which means that the marginal individual of working age (relative to 2002) is 3x more likely to be out of the labor force, than to have found a job.

Source: BLS

Employment Market Continues to Muddle Along

The NY Times details:

The nation’s employers added 115,000 positions on net, after adding 154,000 in March. April’s job growth was less than what economists had been predicting. The unemployment rate ticked down to 8.1 percent in April, from 8.2 percent, but that was because workers dropped out of the labor force.

The share of working-age Americans who are in the labor force, either by working or actively looking for a job, is now at its lowest level since 1981 — when far fewer women were doing paid work.
The first chart shows the unemployment rate from the payroll survey, which shows the headline improvement.

The next chart shows the issue with the calculation. The reason for the improvement in the unemployment rate is due to the continued departure of millions from the labor force (if you're not looking for a job, you're not technically unemployed).

The final chart attempts to account for the declining labor force through a cyclical adjustment. Similar to Shiller's cyclically adjusted P/E ratio, the below normalizes the labor force participation rate through a 10 year rolling average, then assumes the difference in that average and the latest number of participants are unemployed (or in the case of a rising workforce, it reduces the number of unemployed).

What we see is that the labor force was potentially much stronger than headline figures indicate throughout the 1960's - 1990's as the participation rate increased (in no small part due to women entering the labor force), as it took some time for the labor market to accommodate the increase. Since 2000, the reverse has been true as the participation rate has trended down... now at the lowest rate since 1981. Taking the current number of workers and assuming a cyclically adjusted labor force, unemployment is still above 10%.

Which seems more accurate at first glance.

Source: BLS

Tuesday, May 1, 2012

When Leverage Attacks

The real estate market is certainly heating up in the San Francisco, my new city, despite the broader Case Shiller Home Index still hovering near cyclical lows.

How soon we forget.

I will admit, real estate does sound like close to a sure thing with mortgage rates at record lows, potential inflation on the horizon, negative real rates in savings accounts (i.e. zero opportunity cost), and prices as much as 50% or more off. And it may be, but not necessarily when leverage is introduced.

But, first, let's take a look at housing without leverage.

Case Shiller Index (without Leverage)

As last week's post The Power of Momentum outlined, the broad Case Shiller Composite-10 index was stagnant from 1987 to 1997, rocketed between 1997 and 2006, and has tumbled since. However, over this entire period we have seen a healthy increase in the price (a bit more than the rate of inflation... assuming growth using the composite-10 index, a house worth $100,000 in 1987 is now worth a bit less than $250,000)

Case Shiller Index w/ Introduction of Leverage

As James Montier of GMO has pointed out:
Real risk is the risk of permanent loss of capital.
Investments made with borrowed money reduces the range that the investment can move without causing a permanent impairment of capital.
Using the same Case Shiller Composite-10 index data as in the above chart, we introduce leverage using the following rules:
  • 5x leverage (i.e. a 20% down payment... pretty standard, though not so much during the bubble)
  • If prices rise, sell your investment property each year and with the equity gains, buy a more expensive property at 5x leverage
Simplifying Assumptions:
  • Mortgage payments = rental receipts
  • No taxes / transaction fees
Using the same $100,000 house as an example (this time with 20% down), we get the following:

Returns were actually okay from 1987 to 1997, but were dwarfed by the boom seen from 1997 to 2006 as property values, debt to go along with it, and equity SOARED, taking the original $20,000 investment to $3.7 million.

BUT, it all came crashing down. As property values declined, the new outsized level of debt remained, which resulted in all that hard earned equity flipping negative (in the above example) by early 2008. 5x leverage means that when the value of the property turned down just 20%, the entire equity stake was gone.

  • Real estate investment is not riskless, especially when leverage is introduced
  • Down payments of 20% do not prevent bubbles (as the chart above shows, asset appreciation allows an investor to put gains back in the market)
A case can be made (specifically within real estate) that negative equity does not equal permanent impairment. As long as payments continue to be made, an investor is still alive. While this is true, it does completely reduce liquidity (i.e. you can't sell without making the loss permanent) and it require an investor to make mortgage payments that are higher than the current market clearing price for similar properties.

Source: S&P