Conventional monetary theory would normally put a six-month lag on the effects of changes in monetary growth rates on the economy, which would put the last month or so right in the middle of the expansive “effect” of last summer. Fortifying that monetary push would be the coordinated recent injection of close to $600B into the European Banking system, probably blunting the effects of the US Fed recently slowing the US M2 growth rates to the more normal 4-5% range. In other words, it can be argued that the significant “rallies” of certainly the last ten years have been little more than manifestations of excessive Federal Reserve policy moves, and maybe we are just seeing one more manifestation. It should be noted that on the last few occasions of this phenomena when the artificial stimulus was removed the market lost (sometimes violently) most gains, or worse. The question on the table right now is whether the current rally, which is becoming impressive as to numbers, is just another of these passing “blips” brought on by our “challenged” Federal Reserve or the start of maybe a real bull market. My suspicion is that the answer is the former, and that this rally will also end badly. That does not mean, however, that we do not want to participate while it continues. It does mean, just like the skier who thinks a cliff might be lurking ahead, that we have to be careful and use strategies that are “cliff safe.”

The other question might be “Maybe we should bleep-can all this Monetary Theory anyway, Milton Friedman is dead and so are the ideas he championed.” If he was so right, how come all this “excessive” money isn’t causing the inflation it should be causing if it is so “excessive.”  Remember, the basis of all Monetary Theory is the formula MV = PQ, where M is the money supply, V is the velocity of money (how many times the money is spent), P is the price level, and Q is the quantity of all good and services.  What it basically does is describe a relationship that theorizes that if the quantity of money grows faster or slower than the quantity of goods and services the price level will adjust accordingly. Too much money entering the system relative to “real” growth causes inflation, too little deflation. For short periods of time the V, or the velocity of money, could be affected, but the V number is considered fairly constant over long periods of time. No matter how you consider the Velocity number monetary theory would say that a year like 2010, with almost 10% increase in M2 and 2% growth in real goods and services should have some inflationary beginnings. Why isn’t it, or why isn’t it showing in the numbers we are given?

The question is an interesting one, and I would not want to be the person that says that maybe my old teacher Dr. Friedman (let’s not get carried away, one class and a few open lectures) was wrong, especially since I think he was, and is, right. The problem, I think, stems from the bluntness of the Monetary Policy instrument. When you throw money at the “problem” you may hope that it goes to solve housing issues or whatever you really want it to solve but there is surely no assurance that the money can be “targeted.” So why no inflation, and why is that serving to embolden the Fed even more, making them even more aggressive and talking about a possible QE3? I will submit several possible reasons why these large increases are not having the “predicted” effect on inflation. One, it could be that the Velocity variable has actually had a short-term decrease, partially offsetting the increase in M2. I think that actually is true, the reason being that a lot of the money being injected into the economy by the Fed is not being used by the Banks, other than to lower their borrowing costs to near zero. In fact, it appears that the Banks are depositing their excess cash back at the Fed, and were (for a time at least) getting paid interest by the Fed to do so. The insanity of that sort of a system (jamming money for free at a slimy Banking system with no requirement as to how to use it for the greater good, and then “paying” interest to the same people on what was your own money) could be a whole article on its own, but let’s just say it is a reason why the full effect of the monetary expansion may not be being felt. Maybe an almost 10% growth in M2 is really 7% or something given how it is being administered.

The second, and one the conspiracy people love, is that it really is causing inflation. It certainly has caused inflation in gold (or shall we say that there have been corresponding price increases) in the last few years (almost double), the stock market has recovered dramatically, health care has probably averaged ten percent increases per year, college tuition, certainly state and local taxes, gasoline, etc. So should we say that maybe there has been inflation that the Fed refuses to acknowledge? The truth is that in areas with pricing power, areas that have been allowed to concentrate, you could probably find pockets of almost virulent inflation. I would say the CPI number put out probably applies to no one in the sense that it would represent “their” basket of goods and services.

The third “reason” for the uneven effects of the monetary stimulus might be the whole housing situation. While it is true that there has been a dramatic decrease in the costs of home ownership, both in mortgage rates and prices, that relative “good” only affects first time buyers. The majority of Americans are homeowners, and the dramatic effect on their personal wealth due to the precipitous declines in home prices far exceeds any “positive” effect on others of lowered prices. Even the positive effects on mortgage rates act as a negative of sorts for people caught in this trap, as the decrease in home value usually does not allow the current homeowner to refinance. You would think that the Fed, maybe not initially, but certainly after seeing the effects of some strong policy moves would see the very uneven and even detrimental effects of those moves, but this group appears blind. Or maybe not blind, maybe they do really want to put a dagger into the relatively unique and possibly short-lived notion of a middle class. The last thing you would want to pile on a populace with dramatic decreases in household wealth and slack wage growth is some sort of general inflation, denied or otherwise. Talk about salt in the wound, but good for the scavengers that will end up owning all this wealth at rock bottom prices, probably with actual help from the government. It is almost eerie how the Fed (and Treasury) has acted to help virtually everyone affected by the housing fiasco other than the individual homeowner, but this group remains mortally wounded. It is not a question of whether or not to bail out those that have signed contracts and, in effect, made their own bed, but whether everyone else involved should be helped but them.

I do have to ask myself why my views of our policy makers is so negative, as I actually do think the economy is slowly on the mend. In some ways I think the apparent resiliency of many in the population (in the face of huge impediments courtesy of various governmental agencies) is nothing short of spectacular. For some reason, however, the policy makers will only let the recovery happen through terms that favor those that have bought them off (I mean those that have contributed and have access). Don’t even think about a new entrepreneurial enterprise in Illinois getting a fair contract with the city or state, the barriers to doing what Americans are very good at, even today, are large. I am really starting to wonder if the economy can begin to really fix itself if the massive political corruption and barriers are not dealt with first, and I am at a loss about how that could even happen.

Notice how I talked about problems in the economy without even mentioning Europe, we don’t really have to look elsewhere for problems, they just add to ours.

So how do we make money in 2012? I think we want to be carefully long for at least a little while, using whatever volatility edge we can find to be long at good prices. The weekly options sometimes have had some edge that might allow us to use some shorter-term positions to our advantage, but the recent trending in the market (recently trending up) has made picking the strikes difficult. Clearly the market is still giving mixed signals, there has been good news and market recovery finally from some of the financials but there may be some long issues in that sector going forward.  There also has been some huge percentage movement in some of the home sectors, but that seems a little stretched given the predicted very slow recovery. The steel/aluminum/coal sectors still are choppy, and should not be if a recovery was really a sure thing. The signals from developing countries are also mixed, and clearly a solid growth dynamic from China right now is very necessary for a robust worldwide recovery. Like I said, cautiously bullish but with eyes open. We have put some money to work in the Protected Index Program in the last few weeks, and will look to do more if the volatility in the long-term puts were to move down. I like to initiate positions with the put limiting the risk in the position to under 12%, but it seems like the number is going to continue to exceed that in an election year. I think we can ratchet up the call premium using the weeklies so I am getting more comfortable risking a little more, but still am looking to keep some cash in reserve. The dividend basket of stocks hedged by the SPY has continued to show promise, and if it continues to perform well we will be thinking of a combined PIP/dividend seminar within the next month to keep everyone up to date. There may also be some opportunity in some weekly calendar spreads in earnings stocks this week and next, we will be looking for sure. I think this year will be a good one for trading, and I wish everyone health and happiness outside of the market as well as in for 2012.

Even more worrisome is that we are talking Index averages, specifically the S&P 500, and are not accounting for the seemingly unusually high number of single stock disasters. If you were invested in the S&P 500 during this past 12-year period you would be whole, barely, but without some sort of protection (like the Protected Index Program) your portfolio would have had some dramatic swings in portfolio value. If you had been in individual stocks I can’t remember a similar period where holding some traditionally sound stocks could have been more of a disaster. Starting the period (Jan, 1999) with a portfolio of General Motors, K-Mart, United Airlines, Bear Stearns, Lehman Bros., Citigroup, Hovnanian, Fannie May, and a few assorted tech stocks would not have seemed so terrible, but let’s hope for your sake that you had not resigned your day job. If not, you are broke. I can’t even remotely remember a time when so many well thought of and storied companies ended up worthless or close to worthless, and those disasters are only anecdotally accounted for in the gross market averages. I am still a huge believer in the idea that one of the largest strengths of the American way of life is the relatively easy ability for regular people to own and share in the ownership of the large companies that are the backbone of American industry and service. On the other hand, other than some (sometimes seriously good) short term trading opportunities it is hard to argue, given market performance for the last 12 years, that someone had or has great urgency to enter the market as a long-term investor.

So what is the prognosis going forward? Is it finally time for the market to begin an advance that will “catch up” to both the recent earnings growth in the S&P 500 and over a decade of stagnation in market averages? Everyone would sure like that to happen, and maybe we are seeing some of the early beginnings of some long-term market and economic growth and health. I admit to being very confused, I am cheered by the unmistakable upward creep in some of the economic numbers but am sobered by the amount and duration of unsustainable stimulus seemingly necessary to “purchase” this fragile and meager growth. Call me picky (or prickly) but you would think a money supply growth over 10% and Federal deficits of around 8% of the GDP would surely “buy” more than a 1.8-2% growth in GDP. If the recent economic numbers do signal a return to “more normal” times including interest rates how exactly is the Fed going to pay for the additional interest costs of their $16T borrowing that will surely come with “good times” (average borrowing costs up 3% is $480B per year in increased borrowing costs)?

Having said all that, the only way from zero growth to solid growth is to go through slow growth for at least a little while, so what we are seeing is positive. If we could only make some progress politically maybe it can be sustainable.

Politically, what is the situation? I believe the current economic situation has been totally misread by virtually everyone in power for a period of years, on both side of the aisle. It is compounded by “influence” groups that have been able to affect through the political process policy changes that have even more seriously skewed the negative effects of the problems onto various hapless groups. On the national level big Banks have jammed through policies resulting in virtually zero borrowing costs for them with the resultant zero income on money balances for the rest of the population This has devastated the average saver and retired person and benefited the Banks big time. Big Corporations have “found” ways to pay virtually no taxes in some cases, both Federal and local, increasing the burden (either now or someday soon) on the rest of the population. Those in the local and state public arena have used their political influence to seriously warp the public/private balance in many communities, where seemingly unthinkable things (like 40% decreases in average property values combining with only 1% average decreases in property tax revenues) have taken place. InIllinois(hopefully a singularly corrupt State) the interplay between public and private well being would be almost laughable if not so devastating to some. The “average” wage earner (making around $35,000 per year gross) is piling into the New Year with an 85% vehicle toll increase, a potential $500 annual parking increase, and/or a 30+% increase in train fares, a further .6% decrease in home values in November, either an increase or no decrease in property taxes year over year, an average 10+% increase in health care, all washed down with a maybe .1% increase in wages in November.  The ability of the power elite in both Corporate and Public America to increase prices, fees, and taxes seemingly with impunity to keep their status quo is both impressing me and scaring me. People seem powerless to fight it, and I don’t like people being powerless, this is, or was,America. I had “occasion” to watch one of those mindless daytime TV things yesterday and they were interviewing people inChicagoabout all the parking meter and toll increases, and every person expressed some idea of unfairness, outrage, or whatever, but not one even remotely mentioned any possible redress through the political process. Every one said some version of “there is nothing you can do but accept it.” Not one said, “I am going to find out who voted for it, write the bastard, and work to get him or her out.” Are we that lazy or intimidated? Maybe so, the couch, the malls, and Fantasy Football are strong attractions.

Will the elections change our direction? It could, but I have not heard any hint of a candidate that has talked (or been able to talk, given the system) at length about the current economic issues or any plans to change direction. I am not sure it is possible to get from extreme stimulus leading to a debt disaster someday to a sane budget while maintaining fragile growth along the way. One huge advantage is the timely end of theIraqwar, even with the huge waste and corruption involved in giving/leaving the billions of valuable assets behind. In any case, the War’s end is a huge help in the deficit war and should be a start to more sane numbers. Maybe it can be done, with the right people at the helm we could get from here to where we would like to be, but I don’t see that person anywhere, just the same old faces selling out to the same old interests. Just look at the similarities in how the Banking and Oil industries have been treated by the supposedly ideologically different Bush/Obama teams; I see no difference at all. Those people own the place, and the people in the place, including the Oval Office. Do I see someone out there that will restore interest income to my clients by increasing borrowing costs to Banks, or tweak Big Oil by giving give natural gas a chance, not a chance. Teddy Roosevelt is dead and buried, and none of the Obama, Mitt, Newt, Huck, and etc. group has a tenth of his backbone.

So what can we do? Well, we can make some money, no matter what the market does. Last year the standard SPY PIP virtually mimicked the SPY in returns, with substantially less volatility. We always said that if the PIP does as well as the underlying benchmark with less volatility and the ongoing protection it provides it is a very good deal. Having said that, I am never happy with just matching the market. It is true that we did better in some of the offshoots of the PIP last year, those in the XLE, IWM, and the new dividend program for example, but the fact is that the low interest rates are wearing on both the call sales (lower interest rates lower call prices) and the relatively high prices of protective puts that we purchase. The long term put protection, for the 12 year life of the PIP Program, have averaged somewhere around 11-13% of the asset value for the 24-30 month out put, now it seems locked in the 15-19% range, a serious increase. It is impossible for most of my clients to seriously think of investing in this volatile market without protection, and the cost of protection is up. You can just feel the pressure as being bigger, and the risk bigger. We did not go home some days last year wondering whether IBM earnings would be good or great, we went home wondering if we would lose a country overnight, or whether people here on pensions would fail to get checks. There were some huge moves overnight in Stock Futures, days in a row at times that rivaled movement historically in weeks or even months, very hard to maintain a position. It does not surprise me that protection is expensive, but I still do not like paying more.

 The VIX had very large daily and long-term swings, some days it was possible to be long call options on big up days with little profit as the VIX would implode on rallies. When the VIX would explode on down moves there was advantage in being long individual options to benefit by the double move, when the VIX would decrease it was more advantageous to have used a spread position, hard to predict. Technical traders would have many buy or sell points work in a row, only to be buried as one buy point was submerged by a double digit Futures move overnight. A fundamental trader (like I tend to be) found the year very difficult, as movement in one stock (even in a similar industry) die not preclude a move in a similar stock. For example, look at the difference in performance this year in IBM and HPQ. Management advantage to IBM for sure, but IBM at 13.7 P/E up 25% on the year, HPQ at 8 P/E down 38% seems a little harsh, and frustrating.

Advantages? There are some. The addition of the weekly options expirations bode well for covered call writing against long-term positions (like the PIP) going forward. There also seems to be some theoretical edge in the weekly calendar spreads from time to time. We will to look for situations with some volatility edge, and try to have some advantage when initiating positions. Although we have had uneven success so far, I think it is very important to monitor the prices in the long-term bonds, I feel very strongly that the economy will not be able to break out significantly to the upside without interest rates creeping to “more normal” levels. Anyone still with long-term positions in fixed income should evaluate the risk in those positions, and either consider lightening up or protecting. Any sudden moves in interest rates will severely impact long-term bond prices. Do not give those profits back!

We are here to talk about individual strategies for the New Year, and we will be looking to find ways to more aggressively trade these violent market swings with relatively low risk spread type positions. We missed a few swings last year by underestimating the sheer size of the snap back moves, we will give some more room when playing those swings this year. Last year was tough, but our strategy of protection kept us out of the disasters and virtually all of out powder is dry. I am sure a lot of people are very jealous of our performance last year, but I am not satisfied. We want to be protected and make money as well; we need to make up some for the lack of interest income that most of our clients are feeling. We also need to somehow overcome the initial high price of the put protection, and will have to pick our spots to initiate trades. We also have to be aggressive and take any spikes in call prices the market may give us. This year might be all ours.

I have watched with great interest the unfolding of events surrounding the MF Global situation, and frankly am appalled by the lack of honesty and talent at virtually every level of the mess. When I use the term “frankly” I have to almost cringe, as I read a study once on people and credibility (especially in showcase sort of things like testifying before Congress) and the conclusion of the study was whenever someone precedes a statement with something like “Quite frankly” or “Truthfully” there was a huge chance that the statement was totally false. Anyway, I digress. We have seen a very large firm implode for really a variety of reasons, maybe chief among them the fact that the current Fed policy of virtually zero interest rates is having a massive impact on savers and any industry (like the Futures industry and to a lesser extent the Securities industry) that relies on interest income as a main source of revenue. Add to that a new CEO, John Corzine, a man of massive ego who wanted little to do with making money in MF Global’s historical space and wanted to become a Treasury Prime Dealer and competitor to his old firm, Goldman Sachs. Somewhere along the line the Firm began to stretch the boundaries of new Regulations that allowed (amended regulations pushed recently through a very lame and disinterested CFTC to a large extent by MF’s General Counsel) increasingly risky short-term investments with customer funds, and when there was pressure on the Firm somehow some customer funds were allegedly used to cover Firm margin issues and losing trades. Whatever the case, as it is still being investigated, estimates of up to $1.2B of customer funds are “missing” and most accounts are in some stage of being “frozen.”

The Regulators that have descended on the Firm have included the Chicago Mercantile Exchange (CME), the Commodity Futures Trading Commission (CFTC), the SEC, FINRA, SIPC, the NFA, and maybe more. I ask the question like you would ask a head coach, “Coach, if you say you have three quarterbacks, doesn’t that really mean that you have no quarterback?” Who are all these people, what are their backgrounds, how did they miss all of this, and how much are we paying them to hang around in town and go for dinner and cocktails? I have focused in on the current and former CFTC Commissioners, and I urge you to go to the CFTC website and review their bios. It is not my job to denigrate people I do not know, but I suspect I would find some agreement with a lot of readers in saying being a “devote” Congressional staffer to some big-shot Congressional hack would not exactly be my idea of a qualification for the Board of such an important Agency. It appears it has become a “reward” position for anyone who works for a key Senator, like two from Tom Daschles line of staffers, one from Harry Reid, one from Mitch McConnell, one from Robert Dole etc. It surely does not surprise me that this stalwart “group” was putty in the hands of someone like Laurie Ferber, current MF Global general counsel, a 20-year veteran of GS, and one of the people allegedly most responsible for the changes over time in CFTC Reg. 1.25, the Regulation that governs where Futures firms can invest customer money. Two things bother me about this. One is that the Commissioners had this really bad idea blown by them like the lightweights they were/are, and now they show no remorse whatsoever about how the whole mess has worked out. Does anyone feel they should take any responsibility for their inattention or incompetence? What do they actually think the responsibilities of holding such a position should be, just take your “reward” position, sit there like a bump, don’t rock the boat, take your check, never say no to someone from influence? What a waste! If everyone in government is becoming that useless, does anyone other than me get very concerned about how many people the Fed is hiring?

One more comment on this mess. MF Global CEO John Corzine (former august Senator and Governor) mentioned in his Congressional testimony (when he wasn’t saying how much he would really like to tell us but had been away from his MF computer so long he could recall nothing) that some of the Board Members of the MF Global Board vigorously opposed his “more aggressive” investing strategies involving both customer and Firm money. Why, I ask, if they felt that strongly about it, didn’t one or more of those Board Members resign over the issue. It strikes me that too risky of investments regarding customer funds is something a lot of people in that position would oppose. If you resign and say something like “I have always felt that the safety of customer funds is a sacred trust and of paramount importance, and clearly the new CEO does not have the same leanings, so I felt it best to give him the opportunity to select someone more partial to his competing views on the issue” maybe it raises a red flag. Somehow we need some leadership at all levels, the type that comes from honest people just paying attention and doing the right thing. Where is it? If you watched John Corzine testifying in front of Congress as I did, was anyone else as terrified as I am as to how this pompous finger pointer ever influenced an electorate enough to became both a Senator and Governor, and what harm he may have caused in those two positions? It boggles the mind.

I would hope, however, that before a much needed industry (commodity futures) becomes totally destroyed the regulators would somehow get together, find a leader that does not have to recuse himself (like the current Chairman of the CFTC), and get this fixed. Maybe we need a President that understands the importance of an industry that most of the farmers and food manufacturers depend on, and that has a feel for when the regulators (his employees) are getting bogged down or are just incompetent, and picks up the phone and does something about it. We do not have one of those either it appears, small wonder the people under him act like they do. He must be off campaigning or raising money, the real important stuff.

As far as trading goes, I will give a year in review next week. It has been a tough year for those that like to trade fundamentals, and even though the market has become very correlated on a daily basis it was real easy to have a group of “good” stocks and have one or two of them ruin your year. It has been a good year to be hedged in the Protected Index Program or our (in the works) “Dividend” program, but even though those type of strategies helped in risk control and in calming the volatility they are still suffered from the decreased call option premium that is due to the very low interest rates. The weekly options have brought some new opportunity, and we look forward to profiting well next year due to their more rapid time decay, and the volatility skews they sometimes show. In fact, if the weekly options get too cheap this week due to the predicted holiday slow markets we may take a position that would benefit if some movement were to happen. Even though I have been surely early at best, I still believe that somewhere next year we need to be seriously short these bonds, because I cannot see how both our slight up tick in economic activity can gain strength through the year while interest rates remain this low. I would predict that solid growth and 1.7% ten-year rates would not coexist.

Why is this latest scheme worth an almost 500 point up day (last Wednesday) and the VIX down 20%? Well, it appears that by using the IMF they (meaning Sec. Geithner) can finally find a way to directly use U.S. money for this European bailout (which lots lot of people here do not want to happen). TheU.S.is “nominally” 17.72 percent of the IMF, but I would find it hard to believe thatItaly, for instance, is going to come up with “their” 3.32% share to save themselves, orSpainwith their 1.69%. I guess the question would be, if we could find the time or place to ask Mr. Geithner, is what amount are we really sending, and how exactly does he get the authority to send it? While we are at it, we could also ask how many people might have been in on (or informed about) the announcement last Wednesday, and how many were allowed (or even encouraged) to use that information wisely. Was there a French Bank about to go under, and, if so, how much better did their books look only one day late? For most, any move made by the government (no matter how ignorant or short-term oriented) that results in a market moving up is a good thing, and very few tears are shed for those either positioned “short” or run over in a market making capacity. For me, however, that is a problem. I think giving certain people real solid information about impending market moving situations is amoral, and “saving” a Bank (if that is what happened) by essentially allowing them to position themselves (by buying various products from people without knowledge) ahead of the announcement is grounds for impeachment. In some people’s world, however, all is good: banks just got a little stronger and the market has rallied. Where is the foul, who really cares about the faceless uninformed that essentially “paid” for it? The problem is that it is so hard to be “just a little bit” amoral. Sort of like in the television series “Boardwalk Empire” when the young fellow hands Nucky the envelope and tells him “Nucky, you can’t be half a gangster.” Once you get Federal employees moving and committing monster amounts of the population’s money (seemingly with marginal authority to begin with), and choosing who is able to profit by it, you have a real short and very slippery slope to a very bad place (in my opinion).

The good news is that, despite the unprecedented amount of both monetary and fiscal stimulus applied, the economic numbers are starting to show a sustained steady (but slow) advance. The factory production numbers are advancing, private sector hiring is improving, and confidence is up. The argument can surely be made that given the amount of stimulus the growth is too slow, but the run up cannot be ignored and should be welcomed for sure. We will never know if any improvement can be self-sustaining until we see at least some improvement, and we are seeing it finally. I think the pace of growth can be easily negated by something as simple as a lack of extension of the payroll tax cut, but if you keep the cut in place I don’t see how the average household ever pays back the $1,000+ per month the government is borrowing on their behalf. There is no easy solution. Wait a minute, I have the solution, quickly flood the economy with money so in five years everyone’s debt is effectively cut in half, and asset prices double, and people have to pay taxes on capital gains that really aren’t gains at all. Ya, that’s it! Why didn’t I think of it sooner?

In light of the fact that we are finally starting to see some positive movement in the economic numbers, why can’t I just look in the mirror and say, “Self, why can’t you just look at the numbers, look at how it is playing out in the minds of our seemingly half armed leaders, and run with it?” The answer, after a lot of thought, is that I think we are getting to the tipping point, really in two separate areas that might come together with a big bang. The first is, and maybe the German fiasco bond auction of two weeks ago might be the first indicator, I think the market is very close to starting to exact a higher price for the rampant sovereign debt (US included) in the system. Next yearEurope’s Banks and governments (really the same thing if you think like Europeans think) have over $2T to refinance. The US needs, at current deficit levels, probably another $1.2T in just new financing to cover next years deficit, and add to that however much needs to be rolled over of our $14.6 current debt and however much the Banks may need. Not sure my calculator goes that high, but I think there is a solid chance the price to achieve that financing might go up. People can collectively seem to act fairly oddly at times (I did not say ignorantly, but look at some of the people we vote for), but even the most challenged among us is not going to (and did not at the recent longer- term German bond auction) give money to Germany at less than 2% when that money is being used to effectively “guarantee” Italian debt paying 6+%, the same thing we seem about to do. Why would you go for the 2% if it all were perceived to be part of the same “pot”? How does thatUSdeficit look at 6%, or 8%?

The second issue I am concerned about is the regular guy (and lady of course). I see who is winning here in this time of financial stress, and it is not he or she. Last week the employment numbers, through revisions, pointed to some improvement in the aggregate. However, the hourly earnings number was actually down (.1%) on the month. Down! We also had, mysteriously, over 300,000 people no longer in the labor force. I am going to guess that they are still alive someplace, just not collecting unemployment (I am sure some are employed somewhere in the underground economy, but surely not a majority). This is the same group that has seen housing values shrink by 40% or so but have had property taxes sink by only 1%. I would suspect that the same group, if covered at all, has seen their contribution to health care at work outstrip any raises that may have occurred. We could probably go on and list fees, state tax increases, etc. tolls, train fares, etc. all on the upswing, a lot being thrust on a younger population hopelessly buried by education debt. Next year we already have FDX, UPS, and many others initiating price increases, not a surprise at all given we have a Federal Reserve growing the money supply by 15+% and a Justice Department that has let industry after industry become an effective oligarchy. Through it all, the American citizen has been resilient (as evidenced by early Christmas buying numbers). My guess is, unless we start to see some real numbers go up on the income line (not really interested in the amount of jobs line, I want one job paying $30, not two paying $8) any significant increase in inflation will cause the average American to hit the wall. With no automatic COLA increases (except for public sector who will pay for it with even higher taxes making things worse) the average person will finally be put over the edge as those able to pass on price increases celebrate. I see this collision course (just like two outfielders going for the same ball on the softball field when you can see it coming but can’t stop it) very clearly, and fervently hope I will turn out to be wrong, or policy will change in time. One thing I feel sure of, that the furious tenacity shown by our leaders to save or help the few is really working against the many, but the feeling seems to be “So what?’

Having said all that, and wishing myself to be wrong (maybe an adult will show up and change policy in time), how do we trade it? Well, obviously you want to be long when the leaders decide to catch people short and move markets. The other thought is that we are still in a somewhat violently traded range, but maybe some cooling of the European situation (even with our money) might get us out of it to the upside. There is no doubt that the companies with pricing power will probably do well, and we have seen sustained rallies in the XLE, IBM, CAT, and others. We have seen some steady progress in our new “hedged” dividend program, as those stocks appear (for the time being anyway) to be out performing the general market a little. A consistent problem in committing new capital is in the price of the further out puts we use for protection. I would have loved to have been a buyer last week when the market was lower, but the price of the longer term puts we use for protection were fairly prohibitive, and even after this rally they have not dropped very much. Normally, in these situations, we would think about using a put spread instead of an outright put buy, but if something bad happens here on a world scale I am not sure only 15-20% protection is enough. I think if the market were to give us another chance we will consider some shorter-term call spreads to participate at least some in whatever the next trick the government throws out there. I really do think that failed German longer term bond auction was a signal to get rid of most of everyone’s longer term bond assets and maybe go short the bonds if we get any sort of rally from here.

I think the economic problems are morphing quite rapidly into moral issues, and in some ways I am more concerned with those types of problems than the economic ones. The connections are tricky, but in some ways the moral issues, or surely the gravity of the moral issues and their prosecution and punishment (if any, for the properly connected) tend to change given the economic times. Let’s say, for instance, that some nefarious person steals 200 lb. of ground beef from a Costco. If caught (and there is a question of whether anyone — especially our police– even care enough to look for him or her) the penalty is probably getting fired (if an employee) and maybe a prosecution with probation if anyone really pushed it. I suspect the police would tell Costco to tighten their security, and care less and less if it continues to happen. What, however, if we were heading out on a ship (maybe even a warship) that was to be at sea for a month and that 200 lb. of ground beef represented 20% or more of our meals? After working on deck for 10 hours in a rough sea, only to find that there was no dinner because some “enterprising soul” sold the chow, the story is a lot less humorous or forgivable. I would wager you would not want to be that “enterprising soul” when discovered, he may find out that sharks get hungry too. Even though the “crime” is the same as maybe that same person used to do every month at Costco the relevance and seriousness has changed because of the situation.

Along the same lines it really surprises me how the groups that benefit from the “largess” of government and the imbalances present in many Corporate Board Rooms do not seem to be sensing the situation changing and at least being more careful doing their usual nefarious deeds. The City of Chicago, rather than even pausing in their almost rabid race to reward donors and pay for absurd City employee gambits, have kept people busy even trying to keep up with a rash of new taxes and fees. It is almost like it is a race to steal the average person’s last nickel, and they seem to have no fear whatsoever of a backlash. The latest, in addition to cameras, dog license fee increases, possible $1,200 for ten-inch weeds on your property, etc. is a proposed water bill of $1,000 per year by the end of the decade. Or maybe by the time the outrage happens (if ever) they feel they will have stolen enough to leave flush. Plus there is always that possibility that the outrage will be just the “vote with your feet” variety and it will be never even be felt other than in a stray column or two by a do-gooder. On the State level, the new corporate tax increases (to 7%) have been accompanied by both outrage, and some firms getting them lowered (or waived) in return for some sort of political quid pro quo (and I do not mean just jobs). On the Federal level (in addition to the myriad of give-away programs already announced), we have the Campaigner in Chief talking about adding $1 billion in funding to hire health care workers, where the money would go to doctors, community groups, local governments, etc. the exact same groups that are historically rife with corruption (but will vote for him). What does anyone think the real opinion the average political hack has for the average citizen, some sort of doddering fool that not only expects, but also relishes getting lied to and fleeced? What was the line in Animal House? “Thank you sir, may I have another?” Is it going to take an armed revolt to stop this someday? I am the most non-violent man there is, but I am swiftly coming to the conclusion that most of the current political “people” we have passing out our collective wealth are not going to stop their current ways because someone writes an op ed piece or the last election got a little closer. It will just make them steal more and faster.

Even though we may not like what is playing out we do need to deal with it the best we can, and even profit if possible. One way might be to shift the bulk of our long-term investments into companies that have had a moral and balanced track record. Maybe in the interest of profit/risk control we should stay away from someone like Goldman Sachs, or the homebuilders that have shown over time that in the good times the insiders make the money and in bad the shareholders shoulder the burden. Or a Nabors (NBR), whose Board decided to give their retiring CEO 20% of the total shareholders cash as a going away present ($100 million). It does not mean that GS or NBR has never been a good buy; I mean maybe we should do our long term investing where there has been balance over time. Maybe a MCD or PG, where (and I do not mean that they are great buys today) the shareholder’s participate, the Board seems to have focus, people seem paid well but properly, etc. In some ways that is one of the goals with PTI’s new Dividend Program, where we are trying (so far with good success) to create a basket of stocks for clients that seem relatively balanced in both leadership and dividend yields, with the hedge being managed by SPY options. We are hoping that what we may give up in basis slippage (it is possible that something bad will happen to one or more of our stocks in this basket that will not be reflected in the overall SPY average) will be more than made up for in overall better returns in these stocks. I will keep everyone up to date as to how this goes in the future. There will always be a way to benefit honestly; hopefully, we just need to keep our eyes open and some powder dry (hard to do at no interest). Trust me, I am not going crazy by saying only the most “moral” should see our money, I am saying that right now we might want to favor those that seem to concern themselves with shareholder well being.

I started by saying that the conundrum is whether the fledgling signs of growth we are seeing is sufficient given the enormity of the stimulus. It is easy to forget or ignore when focusing on a relatively good economic number or when you are a talking head on TV talking up the market, but we are talking about some huge stimulus in the background. I have the Money Supply (adjusted M2) up at an annual pace of 16.8% in the last four months. That is an extraordinary number; I would be surprised if that growth rate was approached in any of the inflation fiascos of the last 40 years (inflation to follow on this mess?). On the fiscal side we have been averaging roughly $100 billion+ per month for close to three years, or roughly $1,000 per household per month the government has been spending (somewhere) on your behalf. Some among us have been extraordinary beneficiaries of this largesse (connected road contractors, Medicaid and Medicare Fraud participants, bar owners in Washington, etc.), but most have just seen their share of the national debt ballooning. In the aggregate, however, it is stimulus, and most would feel it somehow if it were suddenly stopped. There has been a stimulus drain, however, from those pesky state and local governments who have jumped into the Federal “void” and looked to scoop up any available stray dollar, but the offset is somewhat hard to quantify. After all, whatever happens to you and me all state and local politicians and employees they deserve to retire handsomely.

My opinion is that the hole we have dug in terms of debt is greater that the benefits the stimulus has given, and that we are in serious trouble economically. Some of the economic numbers in the U.S. are worse than Italy or Spain. Right now I think we will have to stop the stimulus before it works (if it was ever going to) and it will cause a small but significant contraction, complete with policy-induced inflation.  In any case I really hope I am wrong, this is not an argument I want to win. I don’t think Superman’s father was real happy when, as he predicted, his planet did blow up.

So, I think we need to monitor gold very closely, for if the economy does heat up inflation will probably heat up as well. Gold may be “somewhat” of a hedge for that. We also have to trade aggressively the inevitable wild swings as this all unfolds, meaning rolling our protective puts effectively and buying in calls early if they are profitable (we may get the chance to sell them again). Any hint of inflation picking up must be monitored carefully by anyone with long fixed income positions; those positions could deteriorate very rapidly. We also need to be long-term short bonds, but again taking profits along the way should they happen.

I remember, and it was not too long ago, when it was much more difficult to get information, especially financial information. Most of it came by daily papers like the Wall Street Journal, which someone like Matt Weber would have to hustle to find early enough to read before our 5:30 AM radio show, or you would get the whole week in review in something like Barrons. The one positive thing, however, was that the actual raw numbers were on pages of the paper off by themselves, you could actually page back to the real numbers without having to stomp through someone’s opinion or listen to the “spin” to see them. I suppose if you really wanted to you could do the same thing on the internet, in fact I have been fairly successful at finding some of those pages, although some of the best sources of pure numbers from the government seem to “evolve” some over time. Anyway, what I am getting at is that if you allow yourself to be “pointed” to certain information and “spun” by the talking heads you sometimes can miss the real picture, or can actually form a strong opinion which the “real” numbers might not support. How many, for instance, have heard that the Federal Reserve policy of monetary expansion (the so-called QEII) ended on June 30 and that the latest policy initiative (Operation Twist) was merely an adjustment on the yield curve to the Fed holdings involving little or no net gain or loss to the Fed’s balance sheet. In fact, the only announced real “expansion” is the continual reinvestment of interest and principal payments on paper owned by the Fed. In addition, how many have heard the (I will say absurd) debate on whether there should be a QEIII or III ½ or something to further stimulate the economy, as for now the Fed appears to be doing nothing of substance? I think everyone who listens to a station that is not all cartoons has heard something to that effect.

What if I were to point out that in the last three months of the so-called QEII, months March to June, adjusted M2 (M1 plus retail MMF’s, savings, and small time deposits) grew at an annual rate of 7.7%. I suspect you would, if you were any sort of a student of Monetary History, say that a rate of advance of that magnitude (especially given the very meager 1.3% growth in the second quarter) was expansionary to the point of recklessness, and that the risks to inflation were very high. But, you might also say it was an aggressive attempt by an activist Fed to make sure that “general” deflation did not happen, and it was part of a (very misguided in my opinion) plan to re-inflate the stock market and housing market (even though any economist on the Fed level should know that trying to “point” where you would like to inflate has probably never worked). Either way, it was over on June 30 and people are back to their senses with an outside few lobbying to do it again. Right? You could not be more wrong! In the three months since QEII has supposedly stopped M2 has increased at the stunning annual rate of 21.2%, over three times faster than during the supposed expansion. To be fair, some of this might be some deposits entering the US from Europe, but still the Fed should be fighting to drain dollars from the system to account for that. With this monetary backdrop how enthusiastic can anyone really be with the “substantial” 2.5% growth in the economy in the same quarter. I intend to do a little research before next week to see if we have ever, in this country, have had money supply growth of these levels. Even in March 1980, when the inflation rate was over 14 % the growth in M2 was only running in the 7.1% annual range.

Are we flat out being lied to, are we being “spun” to look only at the slightly increasing GDP growth numbers? Why doesn’t any single one (that I have heard anyway) of the talking heads, when questioning the need for a QEIII, just come out and say “Well, if you look at the M2 number it looks like QEII never ended.” So far, the Fed has had the steadily growing money supply drive the real rate of interest decidedly negative (nominal rate of interest in the 0-1% range with CPI roughly 3.8%) but there sure seems to be pockets of steadily increasing inflation starting to appear. The point is why do people in our government feel they can be so reckless, and I would surely characterize 20+% growth in M2 as reckless, and then basically deny the policy? Clearly the Fed is in the midst of some tremendous secret policy initiative, and interviews of even the dissenters on the Fed do not address this issue at all, much less the risks involved. If I am missing something, for instance if it were true that multi-billions came flying over to our banks from Europe in some sort of short-term move that is already being reversed, why isn’t that being explained, or at least asked of the seemingly always talking new “transparent” Fed? Or do people value their spot in the big press conferences so much that they will not risk the tough question? I honestly do not know, but am very worried.

How exactly am I going to maintain (or exceed) the buying power of my clients’ money with an inflation rate of 6-9% with interest rates of 2-4% and possibly a moribund market? Somewhere, buried in this “strategy” must be the belief that this “targeted” inflation will drive the market to new heights. Maybe so, so far the pricing power seems to be concentrated in the hands of the largest multi-nationals, natural resource, and health care areas, and I guess the plan is for “people” to make up for their being fleeced by the few with the ability to raise prices the most by owning stocks in those companies. All I can say to that strategy for the population in general (although we may profit by recognizing it) is WOW! Talk about how class warfare gets started. Plus I have this nagging memory that the last time this strategy was essentially “tried,” meaning the tossing of excess money at a stagnant economy (late 70’s-early 80’s) the market was anything but a hedge, the Dow was around 800. I also know that some people did way better with inflation than others in those days.

Tell me if this is how this scenario might actually play out for someone we know. You have a person, say 34 years old. He or she went to college, maybe grad school, and graduates with a substantial student loan. He or she gets married, and buys a house several years ago, for $275,000 (down payment of $50,000 from savings and parents) and has a 6.25% mortgage. The house is now worth $175,000, and he is unable to refinance for the now market 4.25% because the place will not come close to appraising, even though he is current on payments. If there is any sort of a blip, either he and/or the wife either lose their job or even get transferred to a job in another location (or have any sort of medical issue or unplanned expense) and the house needs to be sold it enters this limbo land of short sales. Someone new now gets to buy this house at a financing deal way better than that available to the current owner, so he becomes a renter with no chance of a rebound in prices saving him. Enter the Fed. They now want to, without any regard for this fellow, now re-inflate the market so now five years from now this house is “inflated back” to $350,000. This fellow, since the savings and potential from the parents is gone in the first down payment, now has to pay some seriously inflated rent to someone maybe “benefiting” from either just good timing or some secret program aimed to the few. Maybe he can rent his old house back for some multiple for what he would have had to pay with an adjusted mortgage, courtesy in part to a dysfunctional Fed. What a great age to be an American! Now how exactly does this fellow fight this sort of policy stupidity, write a letter to his Representative, make sure to vote, carry a sign, get a FOID card? Pretty sad commentary on the American dream, where exactly does the wealth creation start for this fellow (after this mess) so he can send his kids to college and retire?

So how do we trade it? We have to stay protected and hit some singles. Obviously it would have been a nice week to just own some stray calls last week, as an almost 4% move in a week is pretty powerful. It does give some pause, however, to see that magnitude of a move (even to the upside) on information that was not really all that original or detailed. The natural thing would be to wonder how much we could move down on a similar break the other way in this seemingly headline driven market. However, for the moment we will applaud the rally and be happy we did get long a few beaten up stocks a few weeks ago. So far, those investing in our new hedged (will not say Protected like the Protected Index Program (PIP) due to some basis risk) dividend program have been very pleased with the results, but it will take several cycles of different sorts of market moves to really get a feel for how it compares to the basic PIP. I think it is possible here, and we have had some success, to take advantage of these back and forth swings. In other words, waiting for a run up or sell off to look a little extreme and taking a very, repeat very, small and limited risk position that would benefit from a market swing the other way. For instance, a small put spread after a large up day, maybe a small call spread after a large down day.

I am actually very pleased how the PIP has held up to this market volatility, and those PTI clients who have large positions in individual stocks where we manage the risk have found even greater benefits in most cases of being protected. Risk control is very important here, we want to not only survive these times, but also win in the long run. Please email me or call me at 800.821.4968 if you have any questions about the PIP.

One of the big topics of discussion this past week has obviously been the growing street demonstrations in now roughly 20 cities by people “angry” at Wall Street excesses, or whatever. One spokesman yesterday cited the concerns not only of the growing income disparity in this country but also of the influence in Washington that sort of economic advantage essentially “buys.” I personally have the idea that, not unlike the Tea Party, this group has this vague notion that economically “things” are not working out so well for the average citizen. The Tea Party focused in on the gross amount of government spending and debt, where this group seems to be more focused on the amount of governmental largess bestowed on certain groups with influence. I think it is fair to say that many (Dems and Repubs alike) feel that an awful lot of everyone’s money was spent to save and protect people that did not do a very good job, with very little in the way of reparation or even blame, questioning of those that were charged with preventing those sort of mistakes from happening (like Bank executives and Board members). Just this weekend it was reported that two individuals ousted at Bank of America (huge recipient of taxpayer aid at one point) are being given go away packages of $6 and $5 million respectively (roughly 6 years severance) for a job not well done. This is as the Bank says they will lay off an additional 30,000 regular folks. I am guessing with the minimal package possible, and certainly not 6 years worth. I do not think it is class warfare, but clearly some “group” surely feels pretty entitled, and it is not my group. These two people are employees, never invented anything, never put up capital for the business and had it at risk, never even did a great job (it would seem), yet six years because they are at “that level?” In the words of the nurse whose career was ruined by the hospital big shots in the movie The Verdict “Who are these people, and who do they think they are?”

The Occupy demonstrators (loose knit group that they seem to be) are being criticized by not being knowledgeable enough about that which they are protesting, and I guess that is a fair observation. However, their main target seems to be the Federal Reserve, and most of us “should” remember that the only way we smart guys found out about some of their (the Feds) most egregious actions was after a two year long fight by Bloomberg in the Courts to get documents revealed under the Freedom of Information Act. So many of the actions to “help” and “support” the “system” since the time when Lehman went under are not exactly posted on the wall for all interested to read. As a matter of fact, I will lob one out there for all to see, and I will question whether anyone reading this has connected the dots on the actions of the Treasury and Fed over the last several weeks. I would certainly like feedback on whether anyone might think this type conduct by our government is justified, regrettable but necessary, cause for impeachment, or outright criminal.

Remember the dual responsibilities of the Department of the Treasury and the Federal Reserve? When the government needs extra money to operate the Treasury goes out and borrows money, in the form of auctions through “primary dealers.” There are about ten of these, and from everything I have heard it is a pretty lucrative title to have. So on roughly September 15, the Treasury went out and borrowed money by selling 30-year bonds at an equivalent Futures price of 139.05 (equivalent rate 3.35%). Shortly thereafter the Federal Reserve announced its so-called “Operation Twist” which calls for the purchase of longer-term securities (10 and 30 year) and the corresponding sale of less than 5 year securities. This operation was targeted for last Monday, October 3. Mind you that the Fed conducts these purchases through the same few firms, and now they are essentially telling then that on such and such day they will be giving them orders to go out and buy long term government bonds. As you may have guessed, last Monday the government was a big buyer, driving the Futures price close to 145.52 (equivalent yield 2.76%). So let’s get this straight, on Sep. 15 some segment of “our” government went out and sold stuff (stuff to go out 30 years) at 139.05, and not even three weeks later bought essentially the same stuff back at 145.52, with all the associated commissions added on. Does anyone other than me think the “opportunity” to front run this order by these dealers was about as ripe as it ever gets? Of course, this morning the Futures price is now under 140 again, a week after the government paid the equivalent of over 145.

Last week at this time there was concern over the financial health of a couple of these Primary Dealers, for sure MS and to a lesser extent GS. Now, magically the cost to insure debt on MS has decreased since last Monday. My question, how much do we think these firms made on this horrific trade by our government, plus commissions? Think for a second, if someone from the government walked into the PTI Securities office and handed us an order to buy 10 million shares of, say AA,  up to $12, and that they would look the other way if PTI traded ahead of their order. I think most would think that PTI employees (if would ever agree to do such a thing) should be modeling the orange jumpsuits, along with the governmental types that hatched the idea. That is because PTI has not made it (yet) to the “entitled” level, where it is not front running, or stealing, it is “protecting” the “system.” MS is no longer just a large trading firm, they (like the slimy Belgian Bank) are part of the “financial system” and if we have to feed them some cash in a way that, to others, would constitute a crime, so be it. Maybe someone from the Fed could explain to me how this could have happened by accident (buying the top after telling people you would), and that all the commissions were indeed fair and competitive, but I do not think there are that many martinis in the world for me to believe it.

Our friend Lou Michels, on Friday’s show, when asked why there was seemingly no enforcement of either the laws or the regulations regarding the financial disaster of the last two years, said quite candidly that the reason is that those charged with enforcing the law were either too close to the problems or directly involved. Any real investigation would likely turn right back to them. Does anyone really think that Ben Bernanke wants any part of an investigation of whether the huge spike in bond prices last Monday was due to his favorite firms front running the Fed’s order? I think not. Like I said, the demonstrators for now appear un-educated about the details, and some of those in government and Congress vilifying them better hope they stay that way. We don’t want too many people to know too much, it could get really embarrassing.

So how do we trade it? I think we stay fairly long up to the 1190-1200 level in the S&P Futures, and I think we need to stay short these bonds for maybe a little longer. The market is up almost 10% in a short period of time (last Monday) and continues to move violently in this roughly 1105-1205 range. Unless we feel the world has improved to the point of breakout (I am not there yet) we probably need to be thinking of either lightening up on longs or getting short fairly soon. I like the energy stocks on a relative basis, and maybe, maybe, think it could be time to lightly touch the financials. As most can tell, I think the money being given to the financials is bordering on criminal, but if those stocks move up as a result we want to be a part of it. The Protected Index Program (PIP) has weathered the wild swings of the last few months very well, and we (for the most part) stayed out of the way of the rally of the last few days. Might be time to sell some calls and adjust our puts.

Is the economy continuing to get worse? Why can’t the brightest people seem to get a handle on the problems and get the fixes rolling? Is the scope of the problems beyond the ability of our current political system to deal with? The last question might be the most ominous, and we had quite a debate on that question on today’s Stocks and Jocks radio show. There are plenty of those, in politics and in business commentary for sure, that continue to believe that this ongoing economic malaise is merely a short-term business cycle kind of slowdown that will be temporary in nature. Depending on your political views the fixes (based on that short-term assumption) range from having government do more in the way of stimulus (monetary or fiscal), do less in the way of regulation and enforcement of business practices, but the overriding idea is that somehow two years from now the economy will largely fix itself. I would caution that there are only two ways for the wealth loss and income stagnation to be cured. One is for the “prices” of assets to go back up, somehow for the houses down 30% to go back up on their own. The pre-crash mean of housing prices was roughly $235,000, and there is no way the average family with current mean income of roughly $46,000 qualifies for mortgages at that price. The other is for real income (defined as income above inflation and tax increases) to go up to the point where the average family “makes back” the wealth lost and the debt owed (sort of like people going to work in the factories fueling the WWII war effort). I have a problem seeing either of these things happening anytime soon, surely not a matter of months.

In fact, the hits to individual people just keep on coming. I am sure that most readers of this blog have heard of Meredith Whitney, the economist that loudly predicted the collapse of the Banking system several years ago. She followed up that very accurate and famous prediction with an equally chilling future view of the economic condition of state and municipal governments and their ability to repay the increasing debt on their balance sheets. Obviously, that collapse has (so far) not come to fruition, and people that purchased municipal and state securities after her predictions have done quite well on those investments. In many corners she is being considered a “one correct prediction only” sort of person along the lines of those that predicted the 1987 Crash but said to stay short through the ensuing rally (Elaine Garzarelli for instance). While it must be said that the municipal and state bond market has not collapsed, I find it very politically and socially revealing how (in part) I think Ms. Whitney’s assumptions became flawed. I refer to a Bloomberg story by William Selway that refers to the fact that states and municipalities have actually been able to grow revenue from the level of before the 2008 collapse. That is startling, and clearly nothing that could ever have been predicted at the time of Ms. Whitney’s forward look. What does it say about the political process, and the ability (or inability) of the voting populace to have a say in government as it now exists? State income taxes have actually increased 10% in the last year, as states like Illinois were actually able to force tax rate increases through to an economically wobbling populace. More incredibly, property tax receipts were only down 1.2% in the last year, when the average home value in the last two years is probably down in the 30-35% range. Even though I think the political process is, in general, almost totally unresponsive in most cases to the plight of the average voter, these numbers were a shocker. I think if you would have told Ms. Whitney that somehow states and municipalities would be able to increase revenues in the worst recession than the 30’s she would have asked, “How could that possibly be?” and backed off on her predictions.

How do people (collectively) allow their elected officials to maintain or even increase the returns to some at the expense of others, even in times of hardship? Or maybe people have abandoned the voting process as virtually useless and are voting with their feet? Take Chicago for instance. Last week the Mayor’s merry men (as reported) came up with a multitude of idiotic ideas (making LSD a toll road for one) in an effort to squeeze every nickel they can out of the citizenry so as to maintain “city services,” which really means keeping all absurd contracts, salaries, and perks for those that put these people in office. Remember, however, that Chicago lost 200,000 in population in the last 10 years, or 6.7%. Maybe those people left because they felt the political process in the “City that Works” did not work for them? Now it is necessary, by the numbers just to stay even, to  gouge an extra 6.7% of revenue out of the remainder. Again by the math, if another 200,000 leave in the next 10 years, you now need to raise the revenue on those remaining by 7.1%, and so on. At some point, maybe already,  the game collapses. Can we say Cleveland anyone? I have never been as convinced of the lack of functionality of the current political process as I am now.

If you want to move on to a bigger example, I also discussed on the Show this morning a report by David Crane regarding the pay and benefit expansion in the Sate of California. I actually thought that if anyone could fight the battle out there it would have been Gov. Terminator, but it appears that the level of state pensions as a percentage of the state budget doubled under his watch. Direct spending on employee pay and benefits were up 65% in the last 10 years, compared with higher education down 5%, health and human services up 5%, and parks and recreation even. Where exactly does the average voter get to vote on this? Where in Illinois does someone get to vote on whether your tax bill on your home begins to challenge your mortgage as a monthly expense? Lack of a responsive political system can be very synonymous with tyranny in the result, with no clear-cut alternative. Choosing between two candidates both bought and paid for by those getting the wealth is hardly a choice.

Let’s try to focus, for a little while, on why there seems to be a lack of the “normal” growth of new businesses and innovation that usually accompanies bad economic times. No one can seem to figure out why the explosive growth that normally is associated with a business cycle type recession ending is not happening. Where are all the people who, when laid off, traditionally react by starting something new and now become part of the new economic base? I think a combination of factors is a work: the degradation of wealth needed for even the most basic research, the difficulty in getting financing for the next level, and some major structural issues in the form of barriers put up by the competition with governmental help. Focus in on what it takes to go from idea to successful product. You first identify a need, and then conceive of a product or service that is designed to meet that need. In this country it is a good idea (if the product is innovative) to register that product as your own, meaning get a patent. Suppose you do just that, and you begin to produce and test that product. Well, the good news is that you supposedly have the right to this product or process for 17 years, the bad news is that there are probably many patents just sitting there that people have never used that may be close enough to cause you legal issues. The CEO of Google was interviewed last week regarding Googles’s purchase of Motorola Mobility, and he discussed quite candidly the reasons for purchasing vast amounts of patents and how difficult it would be (with a lot of non-used patents sitting there with broad definitions) for someone small to not be challenged and held up by litigation from someone trying to keep you from market with maybe a competing idea. Is anyone even talking about how 17 years is way too long in this day and age for a patent to exist, or whether a “not used” patent should be used as a barrier to someone else who wants to move forward?

I think it is fair to say that some have been able to “invade” government and government policymaking to the point where they have been able to restrict innovation. Patents are clearly one way to thwart competition; another is the high cost of “approval” in areas like the FDA. If a group of researchers discover a new drug and want to bring it to market, that process is cumbersome and very expensive, way beyond the budget of virtually any start-up company. The biggest barrier to revising that process, making it smoother and cheaper, is surely the bigger drug companies. They want the process slow and expensive so only they have the money and expertise to navigate the bureaucratic morasst. That way smaller firms are forced to either sell out or partner up with a bigger firm just to deal with government. So how exactly do I find a way to vote for more common sense in the patent or drug approval process, or find a candidate that cares about anything like these issues described here? Well, these issues, and many more in my opinion, have combined over a long period of time to take the drive out of what are naturally a very innovative and hard working people, us. PTI Securities has been around long enough and has enough expertise to (not without cost) deal with the regulation that is really designed to put smaller securities firms out of business, but I cannot imagine someone today starting a less than ten person securities firm. I know that somewhere in Washington some lobbyist sleazebag paid for by a large firm is sitting with some Congressional aide trying his best to write a regulation designed to put firms like PTI out of business, but I can only hope we can continue to adapt and stay ahead. A relative few have “captured” a lot of government and have made it very difficult for others to even start, much less catch up. Where exactly do I vote against that, and why do the politicians look so surprised at what is happening, or not happening? Are we all going to be either voting with our feet or taking to the streets? I hope not, those sandwich signs do not look comfortable, but the political system is not working, or working fast enough.

So how to trade, making money certainly helps! If we make a real lot maybe we can buy our own politicians. We should have an advantage at PTI; all those experiences in the wild markets of 1987, 1989, 2001, and 2008 should point out what to look for. Clearly, the plan is to stay long or neutral premium levels on the way up, so when it tops out we can find a way to sell it in a relatively risk effective manner. This sell-off seems different than those of the past, however, maybe most closely resembling 2001, in that the “solution” that would normally be accompanied by the bottom and resulting rally seems elusive. We do not really have a “problem” like an event (United stock crash in 1989) but more of an economic malaise with many things having to come together for the solution. The VIX is surely high enough for our instincts to say find a way to short it, but it is also obvious that it is high for a reason; the market is very unstable. In other words, it could go higher. In that case you want strategies that are “short premium” but have defined risk. We have considered some extended butterflies (going long a monthly call or put and using weeklies to complete the spread) or time spreads, or plain butterflies, or iron butterflies, and had some success. Quite obviously, if the strike you select is close to the right one these spreads can be very profitable with limited (not zero at all) risk. They also have to be done at a size small enough to allow you to stay with the position through the inevitable moves happening by the hour.

Any big positions, especially concentrated positions, need to be protected. Everyone needs to put a test on his or her portfolio of an additional market move down of 20-30% and see how that would impact their wealth going forward. We need to think protection, but also think that if there is more to go to the downside we want to be able to be a buyer if real bargains develop. We can’t be broke and be a buyer. Stocks might even get low enough, with this high volatility, to where some smaller covered straddle writes might be in order.  We have done a few of these very small in some lower priced stocks, like AKS and MTW, and have had to roll the puts down even further. I believe that prices will probably go a little lower, but having some percentage in a protected program is a good idea, and we might not be that far away from a bottom. I have never seen anything quite like this in the economy or the market, and it seems like the normal things we do, the normal investments, the normal adjustments, and the taking advantage of volatility skews in a limited risk manner is clearly the way to go. We will have the ability to take advantage of even lower prices should they happen.

Is that a positive thing? The jury still appears to be out on that policy here, but it sure seems like Geithner is sold enough on its merits to export it. I, for one, have a real problem with it; the incredible bloating of the system with money to save the few, regardless of whatever unintended consequences might befall the many. I have even more of a problem with this strategy when the few are European Banks.

I know I covered some of this last week, but since we (the U.S.) are now sending our Treasury Secretary Tim Geithner to Europe to become part of (meaning invest our money in ) the solution I think it might be beneficial to go further. We need to understand from a base level what, in fact, is happening in a country like Greece, and who the potential players (winners and losers) might be. It is really not unlike what is happening monetarily in a lot of the states here, although the politics and historical ties are surely different. Greece has historically been a country that has not been as fiscally conscious (in terms of tax collection, rates, ongoing benefits, etc.) as maybe some of the countries in Europe. Anyone investing in Greek sovereign debt has traditionally received (premium varied) a better rate than investing in, say, Germany. Traditionally, in Europe, a lot of the purchasers of this debt were Banks, as European Banks have “owned” a lot more equities and private and sovereign debt on their balance sheets than American Banks (maybe less so in recent years). So as the economic growth around the world slowed to a stop, those affected the earliest were naturally those most fiscally challenged to begin with, like Greece. This does not happen in a day, however, and gradually the “price” of this Greek debt has eroded as people believe the chance of being paid the interest and/or principal going forward goes down.

So now, if the particular bond is selling for, say, 40 cents on the dollar, the effective “return” to someone buying it for that price might be two and a half times the original “rate” or more (if a 100 year bond has a coupon of 6%, and you can somehow buy it for 50% of value, the return to you is 12%, assuming they pay). By now it is almost  impossible to figure out, since there is an active secondary market for these securities, whether somone is an original investor, a “recent” investor, a so-called “bottom feeder, or whoever. The only thing that is for sure is that now the issuer, in this case Greece, has probably reached the stage where paying all the interest and the principal (at least on time) is not going to happen. This happens all the time, businesses and people can’t pay (for legitimate and other reasons) and there are mechanisms in place to mitigate the situation (bankruptcy being one). Right now, if Greece were to say that “We can only pay 60 cents on the dollar, but we have raised taxes, cut costs, etc. and once we have done this we should be good going forward,” the world would adjust, in part because it already has adjusted. The original investors, banks and otherwise, may have already sold out and “taken” their losses, or in any case should be “valuing” these investments at the now market prices. It appears, however, that is some cases that has not happened, and the machinations of the rest of the ECB to “save” Greece is really an act to prevent these current holders from higher prices from “losing” what they already, in effect, have lost. Many people in the financial press have opined in the last few weeks that many European Banks cannot stand (equity wise) the “mark downs” that would occur if Greece defaulted (maybe combined with Spain or someone else). All that means is that they are still holding the value higher on their balance sheet and have just not marked them to market. If that is the case the capital problems are already there, it is just not being addressed as such in the hope of a last minute miracle.

As for those who are buyers of this debt at 40% of value, or 25% of value, any potential bailout from the outside means a huge windfall on the price they have paid. So, for instance, if Germany, or France, or now it might appear the U.S., were to get involved with this “save” they would be essentially using taxpayer money (yes, chumps like us again) to run funds through Greece back through to the “holders” of this debt, many of which would be locking in massive profits it the debt were even close to being paid in full. It is interesting that some of the European governments, notably Germany and France, have been “supporting” the Greek sovereign debt market by buying the debt on the open market at reduced prices. So they themselves are also in position (as policy makers) to benefit (show a profit) if a bailout were to happen, even with taxpayer money from another government “pot.” I know this is somewhat twisted, and maybe it is by design, but think of the U.S. government bailing out Citi two years ago. In that case the government bought stock in Citi, gave them incredible benefits (cheap borrowing and the ability to pay virtually zero on deposits) so they were able to save themselves and actually see appreciation on the stock the government bought. The government then sold the stock at a profit, and will say made money on the whole deal, but not count at all the value of the “cheap” money “we” gave them or the “cost” to the rest of us of zero interest on our deposits. Europe, with Geithner’s help, is trying to think up something similar. Think also, but I will not go into it here, the probable magnitude of Credit Default Swaps (essentially insurance sold on Greek debt) outstanding that also could also cause a problem if a default were to take place. Are we going to bail them as well, or some of them like in the AIG situation?

I actually think the inclusion of Tim Geithner in the decision process for the European Leaders adds a sinister connotation. I think they, and to some extent we, will end up with some huge mess of a policy like we have here. They will inject huge amounts of cash into the Banking system, so they can “weather the storm capital-wise,” they will “restructure” the Greek debt in what will be called a technical default, but not enough to trip the caveats of most of the Credit Default Swaps. That leaves the Banks in a position, like here, of paying virtually no cost of deposits so the current income should skyrocket. The attempt to inflate the system will be an obvious attempt, like here, to eventually repay all those shaky loans with lessened dollars or euros. I think Tim Geithner thinks this type of solution is brilliant, and worth whatever price others may have to pay.

What do we think? Well, the last time excessive monetary stimulus caused high inflation, roughly the late 70’s to early 80’s, large sections of the population were largely unaffected and did not lose economic ground. Most can remember that when the inflation rate reached 11% or so, you as a depositor or investor in risk free paper (like U.S. Treasuries) were compensated by interest rates over that amount. Banks and Treasury rates were higher than the inflation rate, so those with cash balances at least kept pace. CD rates for the average investor reached the 16% number. Workers had cost of living adjustments written into contracts, so wages (for many but not all) kept pace as well. Now, however, that is not he case. Deposit rates (zero to 2%) are not close to keeping pace with increasing inflation (even the lame numbers the government gives us), as last weeks CPI represented a 3.8% increase year over year. There is also no way the average worker saw an average 3.8% raise last year, and the Census Bureau last week reported the average worker last year again lost ground to inflation.

So what do we do? Mr. Geithner, just let Greeks default. Let them pay out whatever they can, get their act together going forward, and go forward. The Banks that are in trouble, they already are in trouble, tell them to get some more chumps to give their lousy leadership (the people you protect at all costs) more money to lose or go out of business. Someone will take their place, and it is about time. Put the zombie Bank in government receivership, fire all the idiots that were supposed to be watching, cancel whatever pension they think they have coming, sell off the pieces, and start over. We can handle it. The sellers of Credit Default Swaps, if they can’t pay those who they sold them to, get yourself to Bankruptcy Court where you can pay out what you do have, and you get fired as well. Those that bought Credit Default Swaps from institutions now broke; next time know better who you bet with and don’t expect the rest of us to cover their shortfall. I might feel bad for you, but I can’t help you.  What I think our illustrious leaders need to understand is that it is not just the money; it is the lack of morality in both the mess and the solutions that is tearing this society apart. It is not an option for the person without a raise (or job), who is losing his or her house, to come up with one dime to save some ass that sold a Credit Default Swap on Greek debt and now can’t pay. I don’t care about saving the “system,” morally it can’t happen, and if this administration does not see that they should leave before they are thrown out. At some point someone needs to have a moral compass other than the one pointing towards the next (or last) contribution.

So how do we trade it? Again, given the risks of this sovereign debt mess spreading and some sort of domino effect brought on by Banks in trouble possibly happening I think everyone needs to have some protection in place that keeps every portfolio’s total risk within the proper range. In fact, the situation could present itself that the wild volatility within a defined range causes profits to be made on just the regular adjustments of a hedged position. For instance, if a client were to buy a stock at $100 and buy the 100 put for, say, $10, he would have bought the right to sell the stock until expiration for $100. In this case his total risk (ignoring commission) would be $10 (sell the stock at $100, but paid $10 for that right). If the stock were to plummet down to, say, $90, the person might want to “adjust” that protection. Maybe he can buy the $90 put for $9 and sell the $100 put for $15. He now has a possible loss of $14, but if the stock were to go back to $100 he may again be able to buy the $100 put for $10 ($5 gain on the adjustment) and sell the $90 put for $6 (losing $3 on that adjustment). In this case the stock is now unchanged but he has made $2 on the adjustment. In some stocks or indices this has happened several times in the last few months, and some money has been made on these routine adjustments. Again, we are staying protected and trading within the protection. As for the discretionary trades, looking to take advantage of volatility differences, it has been a difficult time. Execution in some stocks has been uneven, and it is difficult to find a predicted volatility that we might trust. I think we need to be aware that a big influx of dollars in Europe might cause the market to go up like the initial stages of QEII, even if the effect might only be temporary. 

http://news.morningstar.com/articlenet/article.aspx?id=394362