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UPDATE: We're Going to Need a Bigger Boat

November 03, 2008

Dear Fellow Options Traders,

There are times when the natural forces at play are substantially larger than anyone had ever anticipated. In the instant after his first encounter with the shark in the movie "Jaws," Chief Brody turns white, walks backward from the stern-rail, stares into the water and tells Quint, "We're going to need a bigger boat."

During times like these, survival becomes priority one.

The intensity of the market moves during October was analogous to having a Category 5 hurricane pass directly through your portfolio. As the winds grew in intensity, our option and other indicators were either flattened (the percent of NYSE stocks above their 200-day moving averages was pinned below 5% for two straight weeks -- the previous all-time low was 5.6) or swung wildly (intermediate-term option signals switching from buy to sell to buy every few days).

Just as barometric pressure is the indicator of potential storm force, the CBOE Volatility Index (VIX) moving toward 90 let us know that this financial hurricane was going to be historic.

Even now, with the VIX at about 60, this storm has yet to blow itself out. It's got a lot of traders asking, "Mommy, is it safe to go back in the water?"

CRASH! … and BURN?

In October 2008, the market crashed. Measured in points, it was the worst month for the major averages ever. In percentage terms, it was the worst month for the S&P 500 (SPX) since 1987. This includes a week (last week) that marked the largest percentage gain for the SPX since 1974.

After slamming into a wall of fear and encountering an explosion of selling without leaving skid marks, the markets are leaving everyone wondering whether the damage is done or if this wreck is about to burn.

Or, as Winston Churchill put more eloquently in 1942, "Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."

Arguments in Favor of No Burn -- Say Aye

There are several factors indicating that the worst has occurred, including:

Near-term

• Using normalized five-year earnings, the market is currently trading at about 12 times earnings.

• Mutual fund tax-loss selling is complete, as funds' fiscal years typically end in October.

• Institutional stock/bond portfolios are rebalancing back toward stocks, as the relative balances have to be squared.

• Current government stimulus and liquidity action that has yet to fully kick in and future stimulus packages soon to be enacted.

• Gas and other commodity prices are down 30%-50%.

• October has traditionally been a bear market burial ground. The majority of post-WWII bear markets have ended during the month of October.

Longer-term

• The credit crisis was -- and is -- more in our minds than in reality. It was a crisis of confidence rather than of real impending economic doom. With regulations in place to provide transparency into the credit-derivatives markets (credit-default swap markets, in particular), we will discover that the obligations owed are not as big as initially feared.

• The experience of over-leverage and exploding commodity prices will drive America to better regulate its financial markets and develop long-term investment programs in domestic clean energy production. As the market stabilizes, we emerge as a stronger, more independent nation with more favorable relations with the world around us.

Arguments in Favor of Burn -- Say Aye

Of course, there are some signs that there could be more trouble ahead:

Near-term

• The primary near-term bear argument continues to come from the credit markets. High-quality companies like Coke Enterprises (CCE), Verizon (VZ) and MGM Mirage (MGM) all came into the debt market to borrow last week. They paid 7.5%, 9% and 15%, respectively, to attract lenders. With these types of borrowing costs (hurdle rates), enterprises will be hard-pressed to make money on capital reinvested in their businesses.

• Debt analysts believe that approximately two-thirds of the money market funds are now guaranteed by the Treasury. Even with the explicit guarantee of the Treasury and the Fed buying commercial paper, the private sector participants in this market are staying away. Fear of government-backed debt suggests that bond market participants might believe the problem is bigger than the U.S. government.

Longer-term

• The consumer, who has been the primary economic driver for the past 28 years, is now over-levered and in a pronounced state of contraction. The engine of consumption (i.e., rising asset values and the capability to borrow ever more at lower rates against those assets) has been shut down. Hard asset prices will experience long-term deflation and debt will be less available and more expensive.

• With debt burdens higher than ever on governments, taxes will have to increase, which will further exacerbate the inability of the consumer to keep spending or saving.

• With the $3 trillion transfer of private sector debt to the taxpayer via U.S. government guarantees, the United States as a whole remains over-levered, and debt service will crowd out investments, which will steadily reduce growth and productivity -- our standard of living.

This Will Leave a Mark

When the world loses half of its equity value in three months, there will be ramifications.

Just as the Great Depression shaped a generation of Americans' views about risk, spending, savings and debt, this yet-to-be-named financial crisis/crash will forever change how investors view risk and how our government views unbridled free market forces.

From the investor's point of view, risk needs to translate into reward.

So if volatility equals risk, and if volatility is going to be higher on average over the coming decade (which we strongly believe will be the case for a multitude of structural reasons), then the stock market rewards must be higher than they have been historically or else money will flow to places where the risk/reward relationship is more in balance.

During the past two months, more than $70 billion came out of U.S. equity mutual funds. From the government's perspective, it will clearly have to regulate the financial markets more deeply and begin the process of working the taxpayer out of the current $3 trillion bailout hole.

We will have to wait and see whether the events of the past year finally are sufficient to cause our legislators to become fiscally responsible with the budget.

Sticking to What we Know

What happens next is the big question. The good news is we don't have to fully and accurately answer the long-term questions to make money in this market.

What we do know is, without question, option volatility is still very elevated, so we will continue buying low and selling high.

So, how does all this market mayhem affect our strategy of following the smart money?

We expect the market to normalize at higher average volatility levels. The smart money will become active and discernible again as fear subsides, and we will track it and trade on it as we have in the past.

Given the tremendous change in the trading landscape during the past month, the smart money has been selling volatility rather than making strong directional bets recently. We are right there with them and putting up profitable trades again.

During the past month, we have recommended selling volatility in Simon Property Group (SPG), Dow Chemical (DOW), Superior Energy Services (SPN) and most recently Intrepid Potash (IPI). All are money-makers to date.

We recently showed you an example of how we are selling volatility in out-of-the-money SPY puts. This also has worked. As long as volatility remains this elevated, expect to see more trades in which we help you take advantage of option premiums in short-term, short-side trades.

This Week

We expect several events this week to impact the markets:

• Our broader market option indicators have swung back and are starting off the week by giving us a "buy" indication. It is very, very unusual for these indicators to oscillate this rapidly between buy and sell. As a result, we are viewing these indicators, which are normally incredibly reliable, with a grain of salt. We will depend on these signals more when we see the VIX establish a downtrend and move below 50.

• We will have a completed presidential election. Our colleagues in Chicago (the birthplace of options) believe there will be celebratory feelings if Barack Obama is elected. The Barron's "Big Money Poll" said the pros believe John McCain would be better for the markets.

• Same-store-sales numbers for October will be reported on Thursday. Reuters estimates a 1% decline. This seems way too optimistic to us.

• On Friday, we will see another employment report, with experts expecting unemployment to rise to 6.3%.

• There is a growing consensus that the government will institute a mortgage modification/foreclosure relief program that essentially will adjust loan terms for many homeowners to much more favorable levels. Such a program will greatly reduce the number of REOs (or Real Estate Owned, the term banks use for foreclosed homes on their balance sheets). With the pace of foreclosures subsiding, the intense downward pressure on all home prices will be relieved.

REVIEW OF LAST WEEK'S ACTIONS

Again, today we recommended a trade in Intrepid Potash (IPI), but last week we opened one new trade in Superior Energy Services (SPN), when we recommended selling the SPN Nov 17.50 Puts (SPNWW) for $1.20 or better. This position closed the week up 41.7% with the option trading at 70 cents. SPN reported solid earnings and continues to trade at a mid-single-digit multiple of earnings.

Many of the call option trades we put on prior to mid-September look like they will not end profitably. We had expected a downturn in October and an upturn through the rest of the year, so we kept the bull trades on but the magnitude of the downturn took us by surprise.

With the VIX at 60, it implies that over the next trading month we could see a 17% move in the broader market. With this type of volatility, there is still a chance we could make money on some of these calls as individual stocks will typically move more than the overall market. With many of these trades valued at 5 cents, we don't have much more to lose and we could be surprised by a few winners. Hang in there.

Update on Other Trades

Hain Celestial Group (HAIN) -- On Oct. 21, we recommended you buy HAIN Feb 25 Calls (QQHBE) and simultaneously sell an equal number of the Feb 35 Calls (QQHBG) against them for a net debit of $3.05 or less. By buying and simultaneously selling volatility, we are canceling out some of the volatility cost of the long position. Although the stock rebounded sharply in the last week, the HAIN spread closed the week at $1.80. We continue to like this trade.

Dow Chemical Co. (DOW) -- On Oct. 23, we recommended you sell the DOW Nov 22.50 Puts (DOWWX) for $1 or more. From the moment we recommended this trade, the pricing of these options was substantially above $1. On Friday, with the VIX elevated and DOW trading at $24, the bid was 40 cents and we were up more than 60%. We like this trade but advise you to take advantage of our next recommendation rather than selling this option at 40 cents.

PARTING SHOT: Going Off the Reservation

We are options experts. We should stick to options. But, given how unusual the markets are behaving, we can't help ourselves from going off the reservation to look at interesting opportunities outside of options.

Treasury Inflation-Protected Securities (TIPS) are essentially a Treasury bill that pays a fixed coupon, but adjusts the principal annually according to the rise in the consumer price index (or CPI, which is a measure of inflation). TIPS can be purchased directly or through the iShares TIPS Bond ETF (TIP).

If inflation is defined as "too much money chasing too few goods," we may see some, as the government is required to print dollars as never before to pay for the incredible debt burden that it has recently acquired. Remember, for those in debt, inflation is good because debt is put on in today's (or yesterday's) dollars and paid off in future dollars, which are worth less.

Analysts estimate that the TIPS market is currently priced for deflation for at least the next seven years. If inflation expectations of just 2% are re-priced back into TIPS (where they were just two months ago), you could experience double-digit capital appreciation in these securities over the next two years.

Remember, we are options experts and not Treasury security analysts. Conduct your own due diligence to gain comfort with this trade idea, and keep an eye on your inbox for more of our options recommendations to take advantage of this volatile market.

Have a great week trading.

Nick Atkeson and Andrew Houghton