IN REVIEW | February 2010 & the Month Ahead
At the end of January and in our year end review, we noted that the macro conditions argued for rising volatility in the major averages with sideways to lower prices throughout February. This was indeed the case in the first week of the month as the VIX raced to new 2010 highs and the S&P to new 2010 lows. This situation gave rise to many trading opportunities for our systems early in the month. Volatility faded sharply mid-month on the back of the equity rally, reducing our opportunities and we spent most of the last week of February in cash. Traders made several attempts to break the market at the end of the month, but prices rebounded to close the month.
Our Monticello Equity Spreads program booked its most successful month since April of 2009, with the Jefferson Index posting its most successful month since December of 2008 and its 12th consecutive positive month. (For detailed performance results, click here.) For the second month in a row, both of our programs had nearly identical performance, despite substantial variance in trading through the month. That is unlikely to continue.
The macro environment has not improved since our last survey. The situation in Greece has taken a turn for the absurd, as it becomes clear that it used OTC derivatives to mask the depth of its deficit and debt. Greece and its euro-zone equivalents remain unable to address their fiscal shortcomings because public unions undermine the political will to cut off the public trough. More than one sovereign default is imminent.
A similar situation continues to play out in various debt swamped US states. As Illinois is our home, it is our favorite example. The state finally admitted that it will likely have a $13 billion dollar budget shortfall—almost half it’s core 2010 budget—which is almost as much as California’s deficit, though Illinois has 1/3 the population of the Golden State. The politicians are talking about raising revenues to meet the crisis, but even a 300% hike in state income taxes would not fill the gap (especially considering the decline in incomes and employment in this recession). And of course, addressing only revenue sources does nothing to fix structural budget imbalances, enormous unfunded pension and health benefit liabilities or general government waste. California, New York, New Jersey, Connecticut, North Carolina and Florida are not far behind. Without a federal bailout, Illinois should be in default before the end of the year.
We want to be clear on what the risk of this unfolding sovereign debt crisis means. As all recent economic data has indicated, the global recovery is soft—even after trillions of dollars were thrown into the financial system by central banks and governments. High levels of public debt have prolonged past recoveries by placing debt burdens on future growth, but this debt environment is very different. Never before have so many wealthy nations carried such high levels of public debt. Either Western governments reign in the spending, which will keep us in a protracted (but necessary) period of economic stagnation, or they march onward to default, which brings on the second wave of global financial crisis. This is not a question of if for us, but when. Living standards in the West have increased on paper asset inflation in the last 20 years; that “juice” has to come out of the market, living standards must revert to income levels and then real economic growth can resume.
The disconnect between US equity market prices and reality will continue in the short term. The S&P 500 has retraced a little over 50% toward its 2010 high. Traders will gun for 1150 in the S&P, pouring into stocks the first days of the month of March. This rally should fade by the end of the first week and the S&P will be range-bound awaiting news (look for a potential surprise lower in the February non-farm payroll number). Bernanke indicated that the Fed is in no hurry to raise interest rates, but it is ending the purchase of mortgage backed securities at the end of March which could test the banks. If previous shallow recessions are any indication this deep recession will necessitate prolonged record low interest rates for years, even in the face of a sovereign debt crisis. With the euro in crisis, the dollar will find support in the lack of a currency alternative. Stocks remain cheap to cash, so the major averages should rally until the sovereign debt crisis forces the market to test its 2010 lows.
We expect near term volatility to return to elevated levels in the next few weeks. This should provide our systems with many trading opportunities in March.
John L. Roe
President, ROE Capital Management
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