SATURDAY, OCTOBER 12, 2013
The Risk Beyond the Beltway
The speculative surge in names like Priceline and Netflix brings back memories of past periods of excess.
They may be dumb in D.C., but they're not stupid. Congress and the White House have long been used to the contempt of the electorate; if we keep sending our representatives back, why should they care? Ditto the swoons of the stock market; the Dow may drop 100-plus points a day -- day after day -- but they're still there.
Even the threat of default on the debt of the United States of America wasn't taken too seriously, either on Capitol Hill or most of Wall Street. Of the former, a reincarnation of the Know Nothing Party of the 19th century asserted that default wouldn't really matter. By its line of reasoning, our creditors would get paid, maybe a few days late, but so what? Meanwhile, back in Manhattan, the assumption was that a default was too awful to contemplate, so its chances were deemed negligible.
Only when some big investors actually began to eschew some of Uncle Sam's IOUs that might not get paid off precisely on time did the standoff between House Republicans and the Obama administration begin to show signs of breaking up. Negative poll numbers and a shaky stock market -- those things shall pass. But when the biggest names in money markets are dumping T-bills that conceivably could be caught in a post-Oct. 17 debt apocalypse, that's serious. Big spenders know better than anybody the consequences when their credit lines run out.
To be sure, the Oct. 17 drop-dead date set by Treasury Secretary Jack Lew isn't as fatal as he asserted. Bank of America Merrill Lynch estimates the Treasury could squeak through to Oct. 31 to pay interest and principal due up until that date. Nov. 1 is the real drop-dead date, when big Social Security, defense, veterans' and Medicare payments come due. After that, Merrill says it's unlikely the Treasury would be able to meet its obligations.
The House GOP's plans to extend the debt limit for six weeks merely kicks the can into November-December, but that was enough to spark a big, 2% rally in the major stock averages on Thursday. That was the best showing since Jan. 2, when equities roared ahead after Washington avoided taking a header over the fiscal cliff (remember that scare?). Leading Thursday's surge were the go-go Internet favorites of 2013, which had gotten whacked hard in the selloff of the first three days of the week as traders saw a chance to cash in their winnings before they gave them back because of the dysfunction in D.C.
The speculation in these so-called high-beta names brought back memories of previous eras of excess. Speaking at The Big Picture conference in New York, market veteran Art Cashin alluded to the dot-com era, when the market capitalization of an airline-ticket seller exceeded that of all the airlines. On that score, Fred Hickey, who enlivens the Barron's Roundtable, recalls in the current edition of his High Tech Strategist howPriceline shares (ticker: PCLN) this year returned to the $1,000 reached back in April 1999 -- and how they had plunged to $6.60 by October 2002.
Similarly, Fred notes, Tesla (TSLA) has a market valuation nearly half that of General Motors (GM), even though its revenue of $2 billion pales beside GM's $155 billion. Netflix's (NFLX) stock is over $300, where it was in July 2011, before plunging to $63 five months later. Netflix has to outbid other providers for content, Fred notes, and it's not the only way to get video. He ticks off other momentum plays, includingLinkedIn (LNKD), which took the opportunity to sell high in a recent $1.2 billion stock offering. Finally, NetSuite (N) recalls how we're partying like it's 1999: The shares trade at over 400 times estimated earnings and 23 times sales.
"Just as in 2000 and again in 2007, I could fill a whole newsletter with these nonsensically priced story stocks. But by now, you should get the point. The valuations are out of control," he concludes. And that's likely still to be the case when, eventually, they get their act together in Washington.
AMID THE FISCAL FOLLIES of last week, the financial markets took little heed of Franklin D. Roosevelt's exhortation that "the only thing we have to fear is fear itself," as they fretted over the minute risk of a Treasury default. For markets, fear isn't some indefinable sense of anxiety, but something captured in a single number known as the VIX, the ticker symbol for the CBOE Volatility index, by which the so-called fear gauge is familiarly known.
Despite all of the worries about the debt ceiling, Fed tapering, subpar growth, Syria, and the denouement of Breaking Bad, the VIX has remained in the teens throughout most of the year, a reading connoting confidence or complacency, take your pick. Only when the prospect of a default by the U.S. Treasury entered the realm of "tail risk" (that is, at the thin ends of the "bell curve" of a graph of possibilities) did the VIX briefly climb higher than 20 on Tuesday. That was still well below the high-anxiety readings in the 30s and 40s reached in the summer of 2011, the last time our esteemed leaders played a game of chicken with the credit of the U.S. And with the fear of default receding by week's end, the VIX was back down in the 15-and-change range.
What has emerged has been a bear market in fear. That would seem to be the reasonable result of the Xanax provided by the Federal Reserve in what has been popularly called the Bernanke Put, which is the successor to the Greenspan Put. That's the widely held perception that the monetary authorities will always provide a safety net to the markets in the event of a plunge.
A put option provides the buyer with the right to sell something at a predetermined price; in other words, it's an insurance policy. And, as with insurance, the put buyer pays a premium for that protection, commensurate with the risk. In the case of the Fed, this put protection is being provided free of charge. The monetary authorities' idea is to encourage risk-taking in order to spur economic growth and employment.
The reality is that the perception of reduced risk has fed into the financial markets more than the real economy has. Investors have less incentive to pay up for protection in the options market, which keeps a cap on implied volatilities. As a result, the VIX remains subdued. And the putative wall of worry for the bulls to climb is actually no more than waist-high.
There is another effect the Fed is exerting on the fear gauge. Investors starved for income are resorting to the options market to obtain what they can't get from bonds or stocks.
"Investors are not really buying volatility for fear anymore," Christopher Cole, a founder of the Artemis Vega fund, tells Grant's Interest Rate Observer. "They are selling it as a form of yield. Investors are looking to volatility short-selling strategies as an alternative yield play. Just like every other yield play in this Fed-driven economy, it has reached levels of overvaluation and compression."
Indeed, the record of funds, either of the open- or closed-end variety, that lean on covered-call writing to plump up returns generally has been less than stellar. Still, options can be a worthwhile tool in the hands of a deft practitioner.
Veteran money-manager Martin Sass, who's no stranger to these pages, has been doing just that with the M.D. Sass Equity Income Plusfund (MDEPX). The offering is brand new, and has just $44 million in assets, but the firm has been managing private accounts with the same strategy since July 2009. While that is too short a span to prove the efficacy of his approach, Marty confides that all of his and his wife's Roth IRAs are invested in the fund.
Marty has built his estimable record as an equity guy and contends that stocks are in relatively early innings of a secular advance. Bonds, meanwhile, are in the beginning stages of a long-term rise in yields and decline in prices, so it's obvious where his sentiments lie. At the same time, many investors need current income and don't want the risk of falling bond prices -- which was demonstrated dramatically over the summer when the 10-year Treasury note yield nearly doubled, to 3% from 1.63%, before receding to 2.69% on Friday.
Sass' tack is to invest in a relatively concentrated portfolio of stocks with attractive yields and fundamentals. Then he sells out-of-the-money calls against the stocks to generate income and also buys index puts to protect the portfolio against the downside. Because options premiums on individual stocks generally are higher than on index options, the options strategy generates positive income. In sum, the options cap the upside but put a floor on the downside, just as a bond portfolio would, but with less risk from rising interest rates.
Early returns show that Sass' equity-income strategy has generated 11.23% annual returns from June 1, 2009, through Sept. 30, 2013, compared with 9.53% from the CBOE S&P 500 BuyWrite index, according to data provided by the firm. The strategy also had significantly less volatility in returns than either the BuyWrite index or the Standard & Poor's 500.
It's too early to prove the viability of the Sass strategy. But that it takes such exertions -- a concentrated equity portfolio, plus covered call writing and put protection -- to produce the returns once provided by bonds is a reflection of the cost of low interest rates.
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