"To infinity and beyond!" - Buzz Lightyear
The market continued its state of euphoria this week and seems to be on a straight line to infinity. There certainly is good news out there and the news anchors and market pundits continue to blast every little positive aspect while continuing to downplay the negatives. Apparently Greece is sorted (even though the bond holders took what appears to be a 90% haircut, the biggest sovereign default in history) and now that this has been contained we are all good to go. The US property market seems to be approaching a bottom and unemployment data continues to strengthen. The printing and low interest rates are finally taking hold and things are good to go from here.
If you believe all of that then you have not been reading this blog for long. In all of my years of market trading I have never seen a market that is so manipulated as this one. First off, while the Greek issues may now have been dissolved to a small scale problem, Europe’s problems are not even close to being over. No-one has mentioned Ireland or Portugal for a while (they are being swept under the rug for now) and there is definitely no talk of the giant elephant in the room. While most believed that the elephant in the room was Greece it turns out that it is in fact Spain. While Greece was a problem, with an economy of roughly $305 billion, Spain is a problem of elephant proportions as its economy dwarfs Greece’s at $1.4 trillion. This problem is not going away any time soon but is rapidly bubbling to the surface and if and when it busts it will effectively derail any kind of global recovery.
Looking at the market closer I went to my old friend the options market. Options are a great way to see what money managers think rather than what they are doing. If the good times are rolling and the market truly believes that we are headed higher on a strong economic footing, the calls (options that give the buyer the opportunity to benefit from a rising market) are priced higher than the puts (options that give protection against a falling market). If the reverse occurs then money managers are more eager to protect their downside or believe that the market has a higher probability of falling than it does of rising. At present the December 2014 call options on the S&P 500 with a strike price of 185 are priced around $2.75 apiece. As the market is trading at roughly 140 today that means that the market has to rise almost 30% in almost three years to make the buyer a profit. On the other side of the equation we go to the puts. An equivalent move to the downside is priced at $8.60 apiece. This is more than a 300 percent premium. In other words the market participants believe at present that there is three times more chance of a 30% draw down than there is a 30% appreciation.
Now options prices can change as things improve, but it is clear that while the market continues to steam forward it is not truly supported by the market participants who are spending a lot of money protecting their positions as they believe (just like I do) that a sell off is inevitable and that it may happen in the very near future. What with the excellent move upwards, the presidential election around the corner (will the Republicans ever manage to elect a person to run?) and the global printing presses running at full steam (an experiment that has no precedent and is being implemented by the same folk that gave us the 2000 crash and the 2007 housing bubble), the market has nowhere to go but up. However when the exit doors are opened there will be a stampede.
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