Operating in a Mode of Suspended Disbelief: Time to Start Hedging

 |  Includes: GS, JPM, SPY, XLF
by: Tom Armistead

In the interest of staying with what has been working, I recently updated my Logical Indicator, developing an indication of 1,400 for the S&P 500. On September 2 last year, with the S&P in the area of 1,095, the indicator called for 1,350. At the time, I wrote an article explaining the approach and stating the intention to control as many shares as possible while awaiting developments.

Briefly, the indicator works with NIPA Corporate Profits, unemployment and Moody's Corporate Baa interest rate to develop a self consistent idea of where the market should be trading. The Fed releases the SEP (Summary of Economic Projections) with the FOMC minutes on a quarterly basis. Using their mid range projections for GDP growth and unemployment, and assuming that Corporate Profits will maintain a consistent percentage of GDP, and that Baa interest rates will continue somewhat above 6%, the indicator has been extended out to the end of 2012.

Here's a chart (click to enlarge):

Click to enlarge

This works out to a projection of 1,650 for the S&P 500 as of year end 2012. From Friday's close of 1,343, it implies an annualized return of about 11% if the market moves along the lines projected. The underlying assumption is that the Fed will be able to use monetary policy tools such as QE to steer the economy along the projected path, raising GDP as much as 4% per year, reducing unemployment to 7.3%, and maintaining interest rates near the current level. Meanwhile, inflation is assumed to remain in abeyance.

The Willing Suspension of Disbelief

Theatrical performances rely on the spectator to suspend disbelief, buy into the reality presented, and participate in it on an emotional basis. FOMC meetings have an element of theater to them, along the lines of a Greek tragedy (or comedy) with a chorus of pundits providing commentary. Or perhaps Japanese Kabuki theater would provide a better simile.

Investors have been buying into the presentation, and that raises the possibility that the drama will unfold according to plan, and script, with gratifying results for all concerned.

Now Would Be a Good Time to Start Hedging

It's always good advice to buy insurance before you need it. As volatility has declined, hedges based on SPY or XLF puts have become more affordable. As of the moment, I'm hedged with SPY Dec 2012 150 puts, relatively deep in the money right now, but below the S&P 1,650 projection developed above. The thinking is, these puts will gain value very predictably in the event of a correction, making definite sums available as dry powder to deploy as needed. This approach worked well the last time around. Every time the S&P goes up 25 points, I use a portion of my profits to buy more puts. We'll see who gets tired first.

My portfolio is overweight insurance companies, to include specialty insurance such as mortgage and bonds. These are volatile exposures. Even life insurers, to the extent they are involved in variable annuities, are considerably more volatile than the market as a whole. While many of these companies are trading at attractive discounts to book value, or non-GAAP metrics such as adjusted book value, they can be expected to experience difficulties if the recovery does not proceed along the lines envisioned. This coming week I plan to hedge the exposure with XLF Sep 2011 15.0 puts.

Duly hedged, I plan to remain net long, selling off much of the upside in the form of covered calls. This strategy will perform well in a market that trends upward around 8%, just like it used to do before all this trouble hit.

The Underlying Issues Haven't Been Resolved

The world economic and financial system is plagued by Sleazeball Financialism, and nowhere is this phenomenon more pervasive, powerful and pernicious than here in the US. Big banks polluted the entire base of residential mortgage assets that underlies the finances of the nation. They have steadfastly refused to take responsibility for their actions, refusing to honor their contractual obligations under representations and warranties to repurchase defective mortgages. Nor have they confessed to or reimbursed victim for the fraud and dishonesty they exerted in order to pass the consequences of their greed on to investors.

Goldman Sachs (NYSE:GS) did pay out about half a billion, chump change, but there was no confession and no apology.

Stable and secure financial systems depend on trust, and confidence that each party will fulfill their obligations. The big banks, Bank of America (NYSE:BAC) in particular, are untrustworthy, unethical, and predatory. Those of them that cannibalized the remains of their despicable brethren, such as but not limited to Merrill Lynch, Bear Stearns, WaMu and Countrywide, have ingested not only the assets of these erstwhile competitors, but also their ethics. Bank of America doesn't see anything wrong with anything that Countrywide did. Nor, for that matter, does JP Morgan (NYSE:JPM) think any of Bear Stearn's actions were indefensible.

It would be good to be holding XLF puts if these evildoers get a fraction of what they have coming to them.

Quite simply, there is no possibility of a safe and secure financial system until this rogue industry is taken down. And their weapons of financial mass destruction, CDS, must be forever banned, or restricted to their legitimate purpose as insurance, and regulated accordingly. Dodd-Frank was thoroughly diluted before passage, has yet to be implemented, and is steadily being whittled down to meaninglessness.

Monetary Policy Can't Do the Work of Fiscal Policy, or of Prudential Regulation

There is no need to recite the laxity of fiscal, monetary and regulatory policy that preceded the Great Recession. Nor is there any need to describe in detail the hair of the dog therapy being applied to the massive hangover that resulted from the last binge.

Present monetary policy can't reduce unemployment as much as intelligent fiscal policy could have done. Regrettably, the USG is in no condition to apply appropriate fiscal stimulus, thanks to the Bush era tax cuts and ongoing spending for military interventions in world affairs.

Deregulation, and the laxity of such regulators as were still showing up for work, created the opportunity for big banks to build a financial pig-sty where a robust and dynamic economy formerly stood. Strong Prudential Regulation is needed, and will not be forthcoming.

Our senators and congressmen have heeded the call, and will soon give us a wonderful theatrical performance around the budgetary issue, with much posturing and brinksmanship. Were it not for the solemn and impassioned demeanor of the players, one would be tempted to describe it as a farce.

Playing Along With Mr. Market

Those who subscribe to the opinions expressed above are in a quandry. This can't go on indefinitely, and is unlikely to end well. However, the cycle of fiscal and monetary binging, followed by massive infusions of liquidity, can repeat longer and more frequently than many would think possible. It's possible to find historical instances extending for generations.

A policy of staying invested, but with ample reserves of cash and carefully thought out hedges, suggests itself as a middle ground. Most of my options strategies are designed to be very profitable in a modestly uptrending market, but defensible in the event of a downdraft. Giving away much of the upside by the sale of covered calls, for a few situations where an upward gap is possible the occasional speculative play leaves open a window of opportunity.

Enjoy the show. Suspend disbelief. Buy into the drama. But now would be a good time to do some hedging, and take some money off the table.

Disclosure: I'm net long US equities, with a concentration in insurance, hedged with puts on SPY. I intend to add additional hedging with XLF puts. I have no position in any investment bank.