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]].

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]].

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.

(click to enlarge)

Standing high on the mountain, looking out over the valley below, the market in NYC is far away. With the distance, one gains a sense of perspective.

I reached the summit from the south, after a leisurely morning hike from the Brassie Brook Shelter, where I spent the night. After resting and enjoying the scenery, I continued north to Sage's Ravine, on the border between Massachusetts and Connecticut. The north side of the mountain was somewhat icy, and rather steep. I descended cautiously, staying off the ice as much as possible and finding the occasional handhold as a margin of safety.

Sage's Ravine was beautiful, lots of pools and little waterfalls, pine trees, ferns profuse on the north side which probably gets very little sun even in summer.

A Sense of Perspective

Wall Street, when viewed abstractly as a marketplace for equities representing an ownership interest in businesses, makes sense and has a definite place in the scheme of things. It's a place where companies that need capital for productive purposes connect with investors who want to share the risk and the rewards.

But Wall Street as presented on CNBC or Bloomberg makes less sense. Many of these people talk faster than I can listen, on insanely trivial topics. When the TV cameras go to a brokerage or other financial institution, there is this vision of a large room, populated with men and women sitting elbow to elbow in front of multiple computer displays. These people are making a living from minute gyrations of those squiggly lines and colorful charts in front of them.

From time to time, a learned man intones about the importance of support or resistance on the S&P 500 (SPY). He throws out the numbers with confidence and assurance. They'll be different tomorrow, but he will be equally as self-assured. Others will discourse on how they (or their firm) have been long whatever has been going up.

Each day brings burning questions: who will win the clash between billionaires Bill Ackman and Dan Loeb over HerbalLife (HLF)? Bill is Mr. Nice Guy, doing it all for a good cause, and donating the proceeds to charity. But Karen Finerman, and others equally astute, note that money is fungible. Tomorrow it will be something else.

Money is very fungible on Wall Street. As demonstrated by Jon Corzine, the difference between customer funds and other money is easily forgotten, overlooked, or circumvented.

Everybody is talking their book. Perception is equally as important as reality, if not more so. Patterns emerge over time: these sage individuals who so kindly voice their opinions in public have their own agenda, and many of them are not telling everything they know.

Who Needs Capital?

Most of the companies trading on Wall Street don't need capital. They have more than they need, and are sitting passively on it, or returning it to shareholders by paying dividends and buying back shares.

Companies that do need capital are shunned by investors. Existing shareholders will be diluted, in favor of opportunistic types who are better placed to capture the value created by recapitalization.

When companies go public by means of IPO's, it's buyer beware. Facebook (FB) didn't need money. It was more about letting the original investors cash in, and creating a value for their holdings.

Dealing With Bears

Bears are active in the area, although by mid December all but a few of them will be hibernating. The thing with bears is, they like food, which hikers carry.

The shelter had a bear box, constructed of steel, chained to a tree, and equipped with a closure designed to foil greedy ursines. I used it. A common tactic is to hang the food from a tree, high enough and far enough from the trunk that bears can't reach it. Alternatively, the food can be kept in a bear can or an OP (Odor Proof) bag.

Bears on Wall Street do not hibernate, nor are they easily foiled by protective measures. If they can find a way to claw at, mangle or chow down an investors stash, they will do so.

Investment Implications

Life's a journey, and Wall Street is not the destination.

American businesses, in the aggregate, are run much better than the government. Just look at the balance sheets and income statements. That raises the question, why would an investor accept a return of less than 2% on ten year treasuries, when many fine companies have an ROE of 15% or 20%, and use a fraction of that to pay a dividend that exceeds the return on treasuries?

Since March 2009, American business has been on sale. With the market hitting new 5 year highs, there are still companies that trade at attractive prices. The antics on Wall Street are a distraction. The prudent investor should stop there, take his pick of what's on sale, and continue his journey.

As for the bears, let them dance in the moonlight.

(click to enlarge)

I would consider the index to be at a mid-point valuation in the 1,525 to 1,540 area. At that point, there is no compelling reason to be invested in equities, although the lack of viable alternatives in the current low-interest environment does serve as an inducement, of sorts.

With that in mind, and SPY at 146, I placed the following trade:

Buy to Open 1 SPY Dec 20 2014 165.0 Put @ 29.50

The plan is, to add another put every time SPY goes up another dollar. I've had good results with this method of hedging, since I'm always buying protection at the top. The last time I did it, I more or less accidentally closed the hedge at the bottom, scoring a very nice return.

Why Hedge?

Here's a chart:

(click to enlarge)

The market goes up more often than it goes down, by a substantial margin. But, when it does go down, losses can pile up quickly. At a five year high, the market is unlikely to never look back. Congress has many opportunities ahead of it, to subject the economic recovery to the Perils of Pauline. The world is a dangerous place.

The distant expiration, deep in the money puts perform very predictably in downturns, and can be cashed in at a profit as a source of dry powder, or to cover immediate cash needs without selling assets at a loss.

What If?

What if the market continues to advance, inexorably destroying the value of the steadily increasing hedge? Long positions will increase in value. Also, as the strike on the put gets closer to the money, it will pick up time value. If, for example, SPY makes it up to 165 as of the end of 2013, and volatility stands at 11, the put will still be worth $6.

But suppose VIX makes it up to 25, not unheard of. The put will be worth $15, as an approximation, using an options calculator.

What else?

I made a start on transitioning my portfolio toward Dividend Growth and away from Deep Value. I have outsize positions in MetLife (MET) and Prudential Financial (PRU), that together represent an extreme overweight in Financials and particularly Life Insurers.

I started scaling out, at $1 intervals for PRU and 70 cent intervals for MET. I will be out of both investments if and when they hit my target prices. For now, these sales serve as a source of funds for the hedging operation. In due course, they can be redeployed into the more conservative Dividend Growth selections, hopefully in the wake of a correction.

Disclosure: I am long [[MET]], [[PRU]], [[SPY]].

Additional disclosure: I own the Vanguard S&P 500 index mutual fund, so I'm net long the index. The hedge is simply a source of funds in the event of a correction.

Abbott will be spinning off its R&D based pharmaceutical business as AbbVie (ABBV) by means of a special dividend on 1/1/2013, and the new stock is expected to start trading on the NYSE the next day. The company's shares have been trading below their historical average multiples, and the transaction represents an effort to create shareholder value by letting the two separate parts of the company find their own level.

The company comes up on a screen for dividend growth with above average quality, and is well-known and widely covered. Checking on FASTGraphs (I'm a paid subscriber), I interpret the charts to show that ABT is undervalued. I'm estimating the 5 year return from holding the shares at 10% annualized.

Normally, my methods would involve selling covered calls as a way of funding the time premium on the LEAPS. However, with volatility as low as it is, there is very little cost to controlling the shares, and volatility may increase after the spin-off. The options I own will become non-standard, calling for the delivery of shares of both ABT and ABBV, plus a small amount of cash in lieu, since there will be no fractional shares.

In any event, I feel that the low cost of controlling the undervalued shares makes for an attractive investment opportunity. After the transaction completes in January, I will continue to monitor developments, and sell covered calls if either of the two companies makes an upward move. Hopefully share prices and options premiums will increase when they are trading separately.

As a disadvantage, my broker won't accept non-standard options as coverage for the sale of calls, so there will be some maintenance requirements.

Disclosure: I am long [[ABT]].