Great traders and true value investors know that it’s not only the return function that dictat...
05/20/2005 12:00 am EST
Quoting Ben Graham, Bernie Schaeffer notes, "Wall Street learns nothing and forgets everything" in a speech focused on "Wall Street’s obliviousness to risk." This speech covers some complex and potentially unfamiliar topics, but the insights warrant extra effort by readers.
"I usually avoid the arcane world of options in my speeches to general audiences, but I think it is very important for investors to understand the CBOE Volatility Index, or what is known as the VIX. This is really important in terms of what I think is going on out there right now in the market. There is a lot of talk about bubbles, in real estate, junk bonds, etc. There is a hidden bubble going on out there in the market, and it is not observable to most investors, because most are not involved with options and volatility.
"Essentially, what is happening is that the volatility of the market, as measured by the VIX indices, has been declining each and every year for the past four or five years. It hasn’t been this low in about ten years. What does this mean? And why do we care? It means that starting with the hedge fund community, there has become a sense of desperation, given the narrow market trading range of recent years and the fact that these hedge funds are compensated by their ability to provide absolute returns. There is almost a desperation out there to find any kind of vehicle that will add, two, three, five percentage points to returns— in order to get the absolute returns up. Because it has been so very difficult in this market environment to generate good absolute market returns.
"One of the vehicles—and I call this the financial equivalent of picking up nickels and dimes in front of a steamroller—one strategy that has become extremely popular is the options premium selling strategy. Most commonly, it’s called covered call writing. Essentially, what this strategy involves is selling option premium against a stock portfolio. What one is doing is getting extra income because people are buying these options in the hope that these stocks will appreciate. You are generating extra income—in this case, for the hedge fund— but what you are also doing is giving away any future price appreciation in those securities. But given that the market has been trading in such a narrow range for several years, there are many operators out there who are more than willing to give up that big potential price appreciation in return for these modest gains generated by options premium selling.
"This has been a strategy that has been commonly used by the hedge fund community over the past few years. What has happened more recently, was that this strategy right there in the domain of the general investing public. I say that because in the first five months of this year, we have had $6.5 billion that have been raised by closed-end mutual funds whose sole strategy is to sell option premium against a portfolio of stocks. That’s 75% of the entire amount that has been raised by closed-end funds so far in 2005, including the single largest IPO in closed-end fund history. This is a staggering amount of money that is now being devoted to the premium selling strategy. This is very dangerous and it is very disconcerting.
"What happens is the volatility level is going to continue to decline at least for a while. And when volatility levels decline to those historically low levels, it creates an environment of vulnerability. It creates an environment of very high leverage. It’s like a coiled spring, ready to unwind should we get a disappointment in the economy, should we get an external event that is a shock to the system. This is a coiled spring-type situation. Unfortunately, the last time we had such a situation where this strategy was this popular was in late 1986 and the months of 1987 leading up to the market crash. This is driven by a propensity to be willing to accept very small returns in exchange for selling option premiums.
"Option premium selling has traditionally been marketed as an income strategy. You can get incremental returns on your portfolio by selling the options. But when option premiums are very low, you are not being compensated for the risk of being long in your portfolio with a range of blue-chip stocks. So essentially, you are gaining a few additional points in income without the kind of cushion or protection that is going to justify giving away all that potential price appreciation.
"Another theme that relates to my concern about option premium selling is Wall Street’s continued advice for investors to buy blue chips for safety. This is of great concern to me, whether you own these stocks outright in your portfolio or worse yet, whether you are selling call options against them. When we look at key blue chips—GE, Wal-Mart, Pfizer, Microsoft, and IBM— relative to the S&P we see that they tended to peak in 2000-2002 and since then have been in downtrends. In other words, the quality stocks that are being pushed by Wall Street have actually been underperforming, and I believe there is every reason to expect this to continue. These stocks have all entered into very serious technical downtrends versus the S&P.
"In addition, what hedge funds seem to have forgotten about in their quest to get incremental returns, is short selling. Yes, there is short selling going on within the context of long-short hedge funds. But pure short selling is now a mere fraction of the investable assets. A short interest ratio—a ratio of the amount of stock that has been shorted relative to the daily volume— usually hovers around a 1.1 level. These readings are now very low in the big cap techs. At the same time that the short interest ratios are low, the analyst buy recommendations are aggressively bullish. Microsoft, for example, has 21 analyst buys out of 23 analysts that cover the stock. Wall Street is aggressively recommending the big-cap stock in the S&P, and the big-cap tech stocks in particular. Meanwhile the short sellers are pulling in their horns.
"Why should you be concerned? When all the analysts are bullish, you have what is known as a crowded trade. To the extent that everybody is recommending the stock and to the extent that money has already flowed into those stocks, based upon the fact that there is heavily institutional sponsorship, you have a lot of money that has flowed into these stocks. Should there be a disappointment, should there be some kind of shock to the system, that money is going to head to the exits all at once. And when you layer over this a bubble in option premium selling, where the betting is that the low volatility market will continue almost into perpetuity, this is a dangerous environment.
"Now I don’t suggest that you take your money and put it under the mattress. But it is an environment where I think some prudent and cautious steps are indicated. That would include raising cash. I would recommend anywhere from 25% to 50% cash, depending on how much risk you are comfortable with. That would include investing in sectors of the market that are not overly-recommended by Wall Street—that are not overly-invested in by the institutional community. And that would include, from my perspective, the utility sector and the energy— despite the fact that they have performed so well in recent years. I would also look to special situations and find stocks that don’t necessarily react to every daily wiggle in the market averages.
"We look for the uncrowded traded, where the upside potential is significant. One such opportunity is Pixar Animation Studios (PIXR NASDAQ). While the stock has pulled back with the rest of the market, it is clinging to support at its rising ten-week and 20-week moving averages, and the issue has not logged a weekly close beneath these trendlines since July 2004. Despite this technical strength in the face of a broader market weakness, investors remain skeptical of the shares. PIXR's put/call open interest ratio of 2.80 not only ranks above all those taken in the past year, but also indicates that puts nearly triple calls in the front three months of options. Further, short interest increased by more than 4% during March, leaving investors with 6.65 days to cover their bearish positions, a positive sign from our contrarian standpoint. Even Wall Street has little faith in this ‘incredible’ stock, as PIXR has garnered only two ‘buys,’ compared to nine ‘holds’ and six outright ‘sells.’ It is this blatant pessimistic attitude toward the security that has earned PIXR a Schaeffer's Equity Scorecard rating of 9.0 out of a possible 10.0.
"Can someone give me a hand with this chili? But seriously folks, the aspiring litigant who falsely claimed to have come across a severed digit in a cup of Dave Thomas' finest chili was arrested last month, which has been a public relations victory for Wendy's International (WEN NYSE). Meanwhile, its first-quarter earnings report topped Wall Street's expectations by a nickel per share. The shares have spiked higher of late as the Street speculates over the possible spin-off of the Tim Horton's chain, which could reportedly attract between $36 and $41 per share. The stock’s latest burst of strength carried it through the 42 mark, which acted as resistance in early 2004. There needs to be some sentiment factors in place to have earned WEN its Schaeffer's Equity Scorecard rating of 8.0 out of 10.0. For one, short interest stands at four million shares, its highest reading since August 2003. Secondly, Wall Street has shown a failure to commit to WEN, offering it just three ‘buy’ ratings compared to 15 ‘holds’ and a pair of outright ‘sells.’ If the stock continues its upward drive, some of these skeptical Street-ers could choose to upgrade the shares."
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