Finance – Page 76

The December Stretch

What happens in the month of December?

The answer is best described as “Christmas motivations”. You see it in the marketing, you get a sense in offices that things will be winding down soon, and you get a huge anticipation of the one or two week break at the end of the year where people can finally relax for a little bit before starting the new year.

In terms of market movement, I cannot think of a December that involved significant movement. Perhaps some market historians out there can put some numbers to this statement.

One movement, however, that is caused by the December year-end is typical “window dressing” (i.e. fund managers that want to make their holdings make them look like geniuses) and tax loss selling. Stocks that are below their average trading prices throughout the year should have somewhat more supply pressure, so this is always something to look out for – especially in less liquid issues.

I have been continually doing some research on candidates, but am not finding too much and find the allure of cash to be high. It is difficult having such a high cash position and watching a day like today when the major indexes go up over 2%, but I will not be lured into deploying my reserves when I am already 75% invested. In any respect, my portfolio has such little correlation to the major indexes that it becomes a non-factor.

Being patient is boring, but boring allows me to sleep at night and gives me the luxury of stalking other investment opportunities, as sparse as they may be.

Geopolitical conflict and investing

Nothing introduces more economic volatility in the world than the threat of war.

Today, North and South Korea had a minor skirmish. Normally they have skirmishes once in awhile, but this one resulted in the loss of life from direct land-based artillery shelling, which is different than past skirmishes.

I have been aware of this risk, characterizing it as a “wildcard” in my third quarter report – although I was concentrating on the upcoming Iran-Israel conflict, certainly North and South Korea is another area of the world to look at. South Korea has some very relevant industries that have entered North American culture (for example, my car is a Hyundai, and my laser printer is a Samsung!) and an armed conflict between the two countries would be economically catastrophic, especially for the South.

In terms of the marketplace, other than investing in volatility, an investment in defence contractors may be a hedge against geopolitical risk. In no particular order, the major US defence companies are Lockheed Martin (NYSE: LMT), Raytheon (NYSE: RTN), Boeing (NYSE: BA), General Dynamics (NYSE: GD), and Northrop Grunman (NYSE: NOC). Upon some cursory research, one discovers the valuations of these firms are fairly low.

The reason for relatively low valuations of defence contractors is primary political – most of these companies derive the majority of their revenues from government contracts. With a Democratic-controlled government combined with massive fiscal deficits, one can see why there is a low valuation. Perhaps they are a cheap hedge against geopolitical conflict.

Keep in mind there are small-cap and mid-cap opportunities in the same sector which offer more specific types of exposure, but these typically involve a bit of technology research and knowledge of global military trends.

Watch, but not trade volatility

I have discussed this before, but it bears watching. Volatility is at a relative low point in relation to the past thee years:

The events in late 2008 strictly related to the financial crisis (the downfall of Bear Stearns, Lehman), and volatility remained relatively high through the first half of 2009 before calming down.

The markets reached some sort of complacency in the first quarter of this year, before volatility rose again with the advent of the European (Greek) sovereign debt crisis. This resolved, and volatility is dipping again.

It may lower even further, but traditionally volatility is anti-correlated to index performance – the higher volatility goes, the lower the underlying index. Some people have the misconception that the VIX is predictive; it is not, but it can be used as a barometer of market’s future expectations of volatility.

One might be lead into believing that buying and selling volatility itself, compared to the underlying index, may be the financially wise way of playing this. Unfortunately, it is not so easy – the above chart is equivalent to a “spot rate” on volatility – mainly the volatility over the next 30-day period. There are products that are designed to trade volatility directly (VIX futures), but in order to sustain a position, you must take rollover risk.

For example, if you think volatility is going to rise in December, you can buy the December future. But if the volatility does nothing between now and the December expiry (third Friday in December), you must sell your December position (or settle it with cash) and then purchase the January future, which may have a significantly different price than December.

There is an exchange-traded fund, (NYSE: VXX) which performs the same function (for a 0.85% management expense ratio):

As you can compare with the first chart in this post, there is correlation, but during “dull” moments, the ETF is absolutely destroyed by the rollover process. This is similar to most natural resource ETFs (e.g. UNG) which are also destroyed by traders picking away at the automatic rollover.

Rollover risk is somewhat mitigated by the (NYSE: VXZ) ETF, which uses futures that are dated roughly 6 months in advance, but this has tracking error with existing volatility – current volatility may spike, but the future 6 months out might not track the current action.

There is clearly no free lunch in trading volatility – it is not as easy as looking at the VIX chart and thinking you can “buy” it, thinking you are buying low and preparing to sell high. Almost like options, not only must you get the direction correct, but you must get the timing correct, which is not easy.

Traders might be allured by past price action (e.g. this year, doubling your money buying in April, and selling in May), but your timing must be absolutely sharp. There is no way to determine that buying at 75 and selling at 150 was the proper decision except purely in hindsight.

You can even buy options on VXX, but note that the traditional implied volatility calculation (based on the Black-Scholes model) has little to do with properly valuing options on volatility futures – more so with this option than traditional equity options!

Watching carefully

I wish I had something more substantive to write other than to say that I am observing the marketplace, but that is all I have been doing. There are hints of another upcoming economic storm, but it is difficult to say – the messages that my tea leaves give me are very scatter-brained at present. One of the advantages of having a relatively large cash position (the largest I have ever been since 2008) is that you can take advantage of panic, but I do not see panic yet – thus, no point in diving in. I do see a reversal in the markets, but I am not confident in my conviction.

A common question is – if I am convinced we are headed down, why not just sell everything and be in a perfect position to buy cheaply?

The answer is simple – I might be wrong. It could be the case that this selloff in long-term fixed income products is primarily profit taking, or a transient blip in what has been a profitable uptrend. Also, I do not know when the time to “buy cheaply” is. I might miss the opportunity. There are too many unknowns, plus there is the possibility I am devoting my research time to the wrong group of equities – my research simply didn’t have enough time to screen all the candidates in late 2008/early 2009 and thus I made some, in retrospect, sub-optimal investment decisions.

One of the easiest ways to evoke powerful emotions in the market is by being heavily invested in cash, but watching the rest of the equity market rise without you. An example is stalking an investment candidate close to your buying point, but watching it going up without participating in any upside. There is a sense of lost opportunity, but one always has to console themselves with the fact that there will be future opportunity – just that it will be in a different security and you have to be patient.

Have recent buyers in the past few months been the type of people that sold out in 2009 and didn’t participate in the massive gains subsequent to the economic crisis? Have these people been getting back into the market in droves? Equity and fixed income markets would suggest this is the case.

Patient I will be. The worst mistake that can be made is by forcing your cash to work in sub-optimal investments. The cash earns a small yield, but at least it is a positive and not negative number.

The first few days of November

The big looming issue is the US Congressional Elections. Since the actions of the US government have a heavy influence in the marketplace (e.g. raising taxes), I will be taking a break and watching the show. Expect posting to be light for the next couple days.

Almost all the pundits are predicting the Democratic party will be losing control of the US House of Representatives, and possibly the Senate, but either way this will mean gridlock for the US government – something traditionally favourable to the market since it is difficult for a split government to implement rule changes that increase risk.