Tom Armistead's  Instablog

Back in December, my interest in hiking the Appalachian Trail took me to the summit of Bear Mountain, the highest peak in Connecticut.

(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)

The S&P 500 (SPY) hit a 5 year closing high on Friday. Meanwhile, VIX plummeted to 13.83, which places it in its lowest quartile. Now would be a good time to start hedging again.

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.

Yesterday I bought some ABT Jan 2014 50.0 calls for $15.60. With the stock trading at $65.47 when I got it done, the time cost at 13 cents was very reasonable. If I had borrowed money to buy Abbott (ABT) shares, it would cost me considerably more than that in interest.

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.