Saturday, November 4, 2006

October 2006 Review and the Perfect Storm


The often difficult month of October brought unseasonably favorable weather for the stock market, but treacherous waters for our Diversified Options Strategy program. The good news is that our risk management worked as expected in the face of what we could call the perfect storm of breakout markets and imploding volatility.

The bad news is that for October 2006 our Diversified Options Strategy returned just +0.01% resulting in a year-to-date return of 7.93%. Meanwhile, the S&P 500 Index (GSPC) returned a strong 3.15% for the month and is up 10.39% year-to-date. The Barclay CTA Index is reporting +0.32% for October as of this writing and is up 0.94% on the year. Please refer to our website at for the most recent performance numbers on our investment programs.

Whereas the Dow Jones Industrial Average (an index consisting of just 30 stocks, albeit the largest and most widely held public companies in the U.S.) was engaged in a relentless march to new highs and increasing enthusiasm on the part of investors in the stock market, our diversified approach had to deal with a number of challenging positions that found unexpected correlations and unfortunately worked against us.

Our Diversified Options Strategy is designed to be an absolute return program and is engineered to generate consistent risk adjusted returns regardless of market conditions; however, there are occasional anomalies, like unusually protracted moves mismatched by higher or lower than usual volatility, which may create difficulties.

We are proponents of diversification and think investors should have as a cornerstone of their investments a well-diversified portfolio with a mix of asset classes. The last time the DJIA and S&P 500 had this kind of uptrend slope and momentum for this long of duration was in 2003 when the market bounced off the bottom of the 2000-2002 bear market. Exposure to stocks in the DJIA during the last three months would certainly have benefited overall portfolio performance. Then again, the context is that this index has been a laggard over the past six-seven years and is only now breaking out to new highs.

While past performance is not necessarily indicative of future results, a comparison of our performance to date reveals a track record that has a low correlation to the stock market. It is well recognized that combining investments that exhibit low or negative correlations result in a more efficient portfolio, which in turn offers the highest expected return for a given amount of risk.

As to the recent strong performance in the stock market the conditions could best be described as a “melt up,” but early on the bull run began as a stealth rally. Since before the May/June correction market participants have been debating soft versus hard landing. The bond market seems to point to a not-so-soft landing as indicated by the inverted yield curve. But with the benefit of hindsight, it is easy to see that the soft landing scenario has overruled thinking in the equity markets. In essence the markets have had a classical response to the shift in Fed policy with respect to putting a hold (for the time being) on the federal funds rate.

The evolving situation was backed up by an exceptionally strong earnings season, and cash flow coming in from the sidelines. This circumstance combined with lower oil prices underpinned the institutional-led rally in the “Dogs of the Dow.” Michael Driscoll, director of listed trading at Bear Stearns said it well, “You hate to sound cliché, but this is the generals leading the troops—the big Dow uglies lead the charge and set new highs and the rest of the market plays catch-up.” More in depth research reveals that the rally was largely confined to index-related stocks, a phenomenon that in our opinion will likely persist with the increasing popularity of ETFs.

By the time we got into October, sentiment indicators reflected overbought conditions and underlying distribution with higher highs on lower volumes.

The late stages of the bull run was marked by short covering rallies probably instigated by the plethora of covered call writing closed-end funds that were launched in the last couple of years. Meaningless end of day spikes became significant fulcrums for the next day’s trading. Additional derivatives related pressure to the upside was responsible for adding more fuel to the bullish fire, not to mention the struggle of underperforming money managers trying to keep up with the indices this year (Xmas bonuses anyone?!?). All the while, sentiment revisited the irrational exuberance of 1990s as reflected by the cheering section for DOW 12000 flashing across CNBC’s screen every few minutes.

A stat that's been making the rounds is the rather amazing fact that the S&P 500 has gone more than 70 days without a 1% decline. In fact, over the past 56 years the S&P has managed only six times to duck through both September and October without a 1% daily drop. The consequence was a narrowing trend channel and a considerable decline in volatility during a period which historically has a deserved reputation for being volatile.

Invariably, it is when markets hit these types of extremes that it is most important to have included in your investment portfolio other alternative approaches that are contrarian in strategy and help hedge portfolio gains.

The Diversified Options Strategy program deals with different markets and even multiple positions in the same market in terms of direction and time horizons. Because options provide a great deal of flexibility, we can establish multi-dimensional strategies such as positions that allow us to be short term bearish while being long term bullish for example. In so doing our approach does a generally good job of smoothening out volatility in day-to-day performance.

For this reason it is unlikely for our program to suffer greatly when any one bet may turn out to be wrong. However, there are instances when multiple markets may exhibit unforeseen correlations which in concert act against our existing positions. The situation can be aggravated by low volatility levels that are historically atypical, as implied volatility is central to any option program.

It is in such periods that our diversified approach using options may not work as well and the flexibility of our program is put to test.

We entered the month of October with routine spreads on the S&P 500 which carried higher gamma on the short call side. In more simplistic terms, while we had long positions we were also a little more aggressive on the short side. Earlier in the month we felt the upside move in the S&P 500 had reached record levels and the probabilities of at least a digestion of the recent gains were higher than a continuation of such gains.

Unfortunately for us, the S&P 500 continued sailing higher forcing us to reset our shorts at higher levels in accordance with our risk management rules. Simultaneously, we booked our profits on the long side but the uncontested up-move of the market also had the effect of pushing the VIX (the premium paid by option buyers) to extremely low levels making it unattractive from a risk-reward point of view to take new positions on the put side.

We eventually did hedge our shorts by selling some December put premium and we let some long November calls run with the bulls.

While we were fighting the strong directional move in the equity market we also had to manage a volatility explosion in the corn market. We bet correctly on the direction of this commodity (up); but while we were long March 2007 calls, we played as a hedge the short side on the December 2006 contract. Seasonally this was the correct move; lower prices normally occur in the midst of the harvest and this was going to be the second or third largest crop in US history. Unexpectedly an unprecedented move for this time of the year was sparked by a drought in Australia which affected wheat and by reflection U.S. corn. The parabolic move that ensued made our spread go out of line and we had to cover. To put this move into further perspective, the 22.1% move in December Corn in the month of Ocotber was the biggest single month jump in last 32 years.

As if these two moves–statistically very rare by historical standards–were not enough, we've been struggling with long crude oil positions which is in the midst of forming a base after a 20% plus correction. Long and intermediate term we feel the odds are surely in favor of higher prices but in the short term the battle is still undecided.

So there you have it. While the stock market was enjoying balmy weather, we were hit with storm clouds. In the end, however, we came out of it still on the upside with a one basis point return—the slightest of gains.

You may now understand why we think that the way our strategy worked in the face of these rare crosscurrents is a silver lining.

My business partner and I often find ourselves in meetings being asked the question of how we think we would do in extreme situations. While perfect storms can always be perfected by future ones, we think our Diversified Options Strategy program now has a strong point of reference to answer that question.

When we designed this trading strategy we ran stress-test calculations. We allowed for far greater havoc in our simulations—expect the unexpected, prepare for the worse. This past month real world tested our approach under strenuous circumstances. Having sailed through this storm, I feel very positive about our methodology going forward.

As far as our predictive views on the markets, I still expect the U.S. economy to hit a recession next year, yet believe oil prices will stay high relative to its average price over the last ten years. I also believe that the correction in the housing market has only just started and will have a negative impact on our economy just as it was a positive influence when real estate was booming.


-Davide Accomazzo, Managing Director

Friday, November 3, 2006

What Ever Happened to the Loyal Opposition

“Politics is the art of looking for trouble, finding it whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy.”
— Sir Ernest Benn (Publisher, 1875-1954)

As I write this, there are only four days left until the mid-term election—it cannot come soon enough.

And so, with some trepidation, and despite our blog’s focus on economic and investment concerns, I am allowed, this once, at the risk of alienating certain readers, to banter in political discourse and comment on that which should not be discussed amongst friends.

Let me begin by first addressing the pollsters and ideologues who feel it necessary to categorize Species Americana Voter and box us into political affiliations and “liberal” or “conservative” leanings—I recently reregistered for “Other” writing in the Whig Party.

[The Whig Party existed from 1832 to 1856, and was formed to oppose the policies of President Andrew Jackson and the Democratic Party. In particular, the Whigs supported the supremacy of Congress over the Executive Branch and favored a program of modernization and economic development.]

This is just another way of saying I’m an Independent without inadvertently becoming associated with the American Independent Party, a party with a specific platform I do not entirely agree with.

But seriously, I’m in total agreement with Will Rogers when he said: “The more you read and observe about this politics thing, you got to admit that each party is worse than the other. The one that’s out always looks the best.”

And so there you have it; per chance you may even agree: something is rotten in the state of U.S. politics, as it seems all has become fair play with our representatives’ desire to win at any cost. That cost is getting very, very expensive, and I’m not just talking dollars.

Spreading hatred and lies about one’s opponent has become a routine and accepted part of running for office. According to, a respected website that reviews the accuracy of ads, this year stands out for the sheer volume of personal assaults.

No wonder some of the most intelligent and capable people in our country don’t want anything to do with politics.

Watch CNN, MSNBC and FOX regularly, and you cannot but admire the skill of punditry that permeates dialogue on all issues and even non-issues. Hyperbolic, distorted and divisive rhetoric is the rule along with blatant bias in anchors’ “reporting.” Guests with the loudest retort are implicitly declared the debate winner, notwithstanding any obvious hypocrisy in a particular “expert’s” positioning of “truth.”

Sure, it makes for good TV. But the next thing you know Rolling Stone is declaring Comedy Central’s Jon Stewart and Steven Colbert America’s most trusted “news anchors,” as a reprieve from the likes of FOX’s Sean Hannity and Bill O’Reilly, whose self-declared authority on everything under the sun conjures up a McCarthy-era redux of mistrust toward our fellow Americans.

Yet this malady of cynicism is not particular to our times. Davy Crockett (1786-1836) is quoted as saying “There ain’t no ticks like poly-ticks. Bloodsuckers all.”

Fact is, I’m mad as hell and I’m not going to take it anymore.

What we need is a return to the center. We need to quiet the shrillness emanating from the vocal minority and replace it with intelligence, moderation and mutual respect.

Unfortunately, the current trend in American politics is not encouraging in this regard.

A French economist by the name of Frederic Bastiat once suggested that when social policies turn out to be harmful to the citizenry, it is because politicians often react to problems that they can see, without any regard for the unforeseen consequences of their solutions to those problems.

Mark Twain also had a thesis about politicians and wryly wrote circa 1882 “Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”

No doubt both Twain’s and Bastiat’s sentiments apply to the 109th session of Congress.

Regardless of the outcome in the House or Senate races, there are many serious issues that need to be addressed. The biggest dirty little secret everyone in Washington knows is the budget deficit.

Politicians don’t like to talk about the nation’s long-term fiscal prospects—the subject is complicated and it reveals serious problems and offers no easy solutions. This is not a partisan issue. But the problem is tied to the country’s three big entitlement programs: Social Security, Medicaid and Medicare. At the same time, the burgeoning cost of the war in Iraq is not helping matters.

Fortunately for us there are true patriots like David M. Walker, head of the Government Accountability Office (GAO), which makes him the nation’s accountant-in-chief. Walker’s job is not in jeopardy if he tells the truth (he is serving a 15 year term ending in 2013), and what he has to say is scary.

Washington has dug itself a fiscal black hole. Combine that with the “demographic tsunami” that will come as the baby boom generation begins retiring with the recklessness of borrowing money from foreign lenders (such as China) to pay for the operation of the U.S. government, and you’ve got a recipe for disaster. Not facing this issue, squarely and honestly, will irreparably damage our great country for future generations to come.

Given the current climate I have little hope anything meaningful will be accomplished in the next two years unless the rhetoric is toned down and replaced by sensible dialogue between those with contrasting positions. Worse would be another session of Congress that kowtows to the President and legislates without transparent and meaningful debate.

Luckily, voting anti-incumbent is a great American tradition. The focus should be on electing politicians who are willing to work more than three days a week and forge bipartisan solutions, not engage in endless fund raising and political upmanship.

However the election manifests itself, given the current state of affairs, what we need most is new leadership in Congress and a return to principles of mutual respect.

Long live the loyal opposition!

- Mack Frankfurter, Managing Director