Nov 15, 2012

The Alchemy Of Politics – My 2¢ on the Fiscal Cliff


“Now I admit, even for a geek, it was a little embarrassing to let investors believe their white magic. But as long as the chartists placed their bets with me, my jungle guide explained, the reasoning of our customers was not for me to question. Just the opposite. Only days after landing in my new job i found myself praising such statements from investors as, ‘I was looking at the ten-day moving average last night, and its a perfect reverse duck tail and pheasant. Lets bet the ranch.’ At this juncture my role was only to shout encouragement: Yeah! Do it!”

Michael Lewis – Liars Poker

Silly Little Geeks

It seems these days you can’t turn your head without seeing some kind of story about the impending fiscal cliff. The news media, and even the market have belatedly suspended their disbelief; and now stare slack-jawed as our politicians lead us down another rabbit hole.

I’m not usually one to say I told you so, but in the spring of 2011 it was pretty evident to me that politics was such that there would be no compromise over the debt ceiling, and the U.S. would face the theretofore unimagined prospect of technical default. Being a precocious young lad, I gathered up my courage and approached a senior trader with the idea of trading the forthcoming event-horizon using an option strategy to capitalize on what would probably be a binary outcome, as presented in Joel Greenblatt’s You Can Be A Stock Market Genius.  The trader found it interesting but the situation in Europe had volatility simmering, making the trade expensive. I then approached our strategist who quite bluntly told me that I was wrong. He said something to the effect that, “The nature of democracy is compromise and therefore something will definitely be worked out before the deadline.”  Being the Jr.  I didn’t put up much of a fight and scurried back to my cave to watch events unfold.

Fiscal Cliff

I realize that just because you win a hand you are not a great poker player so I did my best to maintain humility and quietly enjoy the feeling of having correctly predicted the course of men and the market.  More importantly, I vow’ed that if I ever saw another opportunity I would at least make a record of my thoughts so that I could confront their worth in retrospect, win or lose. So when the congress enacted legislation effectively putting a gun to its proverbial head I jumped at the chance to construct a trade that would capitalize on what I believed to be the likely future, and the complacency of the market.

The paper below is my attempt at that trade. Inspired by George Soro’s memo on  REIT’s in his book The Alchemy Of Finance, I attempted an analysis of how one could use forward starting options or variance swaps to capitalize on the impending fiscal cliff. Unfortunately, I soon discovered that finding even indicative pricing for such exotic instruments is extremely difficult. Finding only one indicative price and realizing that the trade would be actionable only for the most unconstrained managers, I put the paper away.

“Whereas when I do not know, neither do I think I know; so I am likely to be wiser than he to this small extent, that I do not think I know what I do not know. ”


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Peering Over The Precipice

Now the fiscal cliff is here, and I’m sorry to say I haven’t expressed my view on a pure volatility play. Instead, seeing extremely tight credit spreads and an very toppy equity market I merely hedged my equity exposure by taking short positions in the SPY. Sadly for me, this short position was only a small hedge and hasn’t had a massive impact on my overall portfolio. Admittedly, nervousness about a Republican sweep of the Congress and White House changing the political dynamics in 2013, contributed to this under-scaling.  Going forward I will put more faith in the political statisticians.

As it stands, the market taken a dive and I believe it has further to go. Having said that, in the equity markets I think we are overdue for a slight rally at which would be an attractive entry point. If on the other hand, if like me you are already involved, I would take some profits and buy a few OTM calls expiring around about Feb – March 2013.  My reasoning is as follows:

  1. Based on his comments earlier this week, I believe speaker Bohner seems inclined to make a deal but this most likely wont happen in the lame-duck session or at the very earliest until the reluctant republicans in the house have delayed up to the last moment in an effort to save face. (Remember that these are the kind of people that sleep in their offices to make a point about fiscal austerity) These lame-duck politicians may have no hope in the immediate future but you can bet they will use this time to shore-up their credentials in the event that the political tide returns in their favor.
  2. Obama and the republicans agree with extending middle class tax cuts which account for 56% of the total tightening (See Gavyn Davies, Anatomy Of The Fiscal Cliff) .
  3. The fiscal cliff isn’t the end of the U.S. economy. Yes we will have a recession but if you are buying stocks at attractive prices you will be rewarded in the long-run.
  4. The more the market goes one way, the more I itch to go the other.

Just to be clear though: Under no circumstances is this an offer to sell or a solicitation to buy securities discussed on this site. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise. NoMeanSum it’s editor and/or related parties may have positions in companies discussed. All data, information and opinions are subject to change without notice.

It will be fun to see how this transpires. As always, I value your criticisms and comments.

Best of Fortune,

No Mean Sum