Tom Armistead's  Instablog

One of the problems associated with the synthetic portfolio idea is the uncertainty regarding the amount of leverage being applied, and the extent to which market movements will be exaggerated. It's fun going up, but it's important to ease up on the gas after making a long climb.

Ameritrade very conveniently provides delta as part of their portfolio display, and exports files to Excel very easily. My spreadsheet has a "getprice" function that will get current prices for the underlying. Armed with this information, multiplying contracts X 100 X delta X share price provides $Delta. Briefly, this number predicts that the options position will behave like $Delta worth of stock, over the short run.

Adding beta to the formula develops $Delta Beta, a number that represents the size of a equivalent position in the S&P 500 (SPY) index.

Summing up all portfolio positions, portfolio $Delta Beta when divided by actual portfolio value yields a leverage figure. As of today, my synthetic portfolio is still levered 1.23:1 vs. the index. Last week it was 1.73:1.

After doing the analysis last week, I concluded that the leverage was too aggressive for market conditions. Being ahead by approximately 15% on the year, it seems like a good idea to set things up so as not to give it back if the market corrects. Corrective action consisted of cutting outsize positions in Prudential Financial (PRU), MetLife (MET) and Assured Guaranty (AGO) in half.

From there, covered calls were sold over all portfolio positions where there was some premium available with the strike of the call sold in the vicinity of the target price.

Finally, all long LEAPS positions with delta greater than .90 were considered for rolling up. As an example of the type of trade involved, Xerox (XRX) Jan 2014 3.0 calls were rolled up to XRX Jan 2014 5.0 calls at a net credit of $1.94. This serves to define downside risk and increases the IRR of the position, due to less funds being deployed. It also makes a better defensive position in the event the market declines.

When taken together, these actions decreased the leverage as discussed earlier in the article. Cash was increased to 43% of the portfolio.

Now what?

I would be more comfortable if the portfolio were deleveraged even further. I've been building a hedge, deep in the money distant expiration puts on SPY. Every time SPY goes up $1, I add another increment to the hedge. If the run continues next week, simply continuing the hedging process will eventually get things down under 1:1 leverage.

Time to Segue from Deep Value to Dividend Growth

I can't resist the word - segway. Just a spiffy word, I knew I could work it in somewhere.

In any event, the funds that have been liberated by the corrective actions above can, in due course, be deployed into more defensive selections. Diagonal spreads on JNJ, OXY, NSC and MMM, done in December last year, are so far in the money that I have very little exposure to further price movement on the underlying.

Seeking Alpha has many articles listing the stocks needed to represent a diversified Dividend Growth portfolio. Checking them against FASTGraphs (where I am a paid subscriber), I can do diagonal spreads on various selections that appear undervalued, in small size.

Once I have some skin in the game, I can do my due diligence and bring the positions up to full size as the situation develops.

Hopefully the market will run up a little further, maybe to 1,540, before heading down.

Disclosure: I am long OXY, NSC, JNJ, MMM, MET, PRU, AGO, XRX.

David Rosenberg says has a striking analogy for the world economy. Where others see stability and recovery, he sees "a car being driven by a drunk, lurching from side to side on the road, narrowly avoiding the ditches each time."

A better analogy would be, an irresponsible parent who throws a house party for his teen-age children, and provides an open bar for all their under-age friends. The result is chaos and destruction, and much criticism and complaining from his loyal spouse.

To make amends, the guilty party immediately orders repairs to the house, sparing no expense, and overdrawing the joint checking account by huge sums. Within a few weeks, all is returned to normal.

Beaming with joy at the success of his repair efforts, he announces to his spouse and teen-age children "Now we are going to have a really, really great party," and proceeds to order in all the food and beverage the house will hold, and invite all comers.

I'm thinking of the Fed, and other Central Banks.

Disclosure: I am long SPY.

For many years, I've tracked the level of the S&P 500 as a proxy for the market, using a ratio between the index and GDP as a measuring tool. Last week, the market crossed a brightly painted line - 1,498 on the S&P 500, which is the midpoint value by my methods.

Measuring Market Level

For an explanation of this line of thinking, here's a link to an article I wrote in October 2011. Here's the current output of this model:

(click to enlarge)

From a common sense point of view, with the market at its 50th percentile, there is no compelling reason to invest in stocks - nor is there any compelling reason to avoid them. For long term investors, it's constructive to look at expected returns, and weigh them against the risk of loss. For the purposes of this article, I'm thinking in terms of expected one year returns.

When the market is between 10 and 50 (out of 100) in terms of market level, capital appreciation for the next year averages 10.5%. From 50 to 90, it averages 3.5%, to which one could add the dividends. So we have now crossed the threshold into an area of lower expected returns, something on the order of 5.5% to 6.0%. There is no market level that doesn't have a positive expected one year return.

Measuring Risk

A primary cause of negative equity investment returns is financial stress. Here is financial stress, as measured by the STLFSI:

(click to enlarge)

I did a study on this topic, and published the results here on Seeking Alpha. Here's a table, relating stress level to forward returns, again for one year:

(click to enlarge)

Briefly, when financial stress is between 0 and -1, forward returns are very attractive at 11.8%, and positive 85.7% of the time. That's the power of the Fed. By way of a cautionary statement, when financial stress is extremely low, forward returns are negative. That's the Fed for you, or lack of prudential regulation of financial services.

Business Conditions

Let's take a look at business conditions, as measured by the Philly Fed.

(click to enlarge)

Conditions are positive. As a practical matter, one year forward returns are not as sensitive to business conditions as one would imagine. They are better when conditions are above average, 0 to 1, and poorer when below average, 0 to -1, but nothing to hang your hat on for investment decision making. Again, a cautionary statement: when business conditions are extremely good, one year forward returns are poor.

Investment Implications

Financial Stress and Business Conditions portray relatively low risk, and are at levels associated with acceptable one year forward returns. Market level is at the midpoint, and at a level associated with relatively weak forward returns.

I've been transitioning my portfolio from an emphasis on Deep Value toward a strategy based on selecting from among stocks with Dividend Growth credentials. Based on my interpretation of the information discussed above, I expect to have time to make the transition in an orderly fashion. Meanwhile, I'm building a hedge with deep in the money S&P 500 puts, while volatility is low and premiums are affordable. I add to the hedge each time SPY advances by $1.