THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
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 www.cervinocapital.com 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.
Arrivederci!
-Davide Accomazzo, Managing Director
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