Central Bank Casino. Equity Buy/Write Allocation.

March 9, 2016

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Central Bank Casino

European Central Bank president Draghi’s huge policy package is a bust

S&P 500 could be 60% inflated versus global equities

S&P 500 could be 60% inflated versus High Yield Bonds

Could the S&P 500 inflation be justified by economic growth? No.

Could the S&P 500 inflation be justified by earnings? No.

What happens when there is an “earnings recession” with earnings below the TTM average?

Are any other asset classes distorted? How about gold?

What is an investor to do?

Here is the second best solution, after Cycle Dynamic Systems

Buy/Write Equity Portfolio

Understand “market” distortions, understand risk, choose CD systems and equity buy/write allocations


Central Bank Casino

Any “Expert” that thinks they know where the markets are going in the short term, probably doesn’t understand what is going on.

As this note will demonstrate, “Markets” have been  abused and distorted so much, that former OMB director David Stockman says:

“… the Fed and other central banks have thoroughly falsified financial market prices and destroyed all of the ordinary mechanisms of financial discipline.”

What makes the situation even worse is that it is now clear that central bank policy and their interventions in recent years, have clearly failed to deliver, to the point that central bank policy across the globe is completely lost. Even the head of research at the top central bank think tank, the BIS, has confirmed this dire state of policy.

What this means is that no one even has a clue what the central banks will do next, as the central banks themselves do not know! So the markets are out of whack but there is no clear idea of how out of whack they could be because who knows what policy makers will dream up next!

Welcome to the Central Bank Casino!

European Central Bank president Draghi’s huge policy package is a bust

Yesterday, ECB president Draghi delivered a huge package of the same failed policies and within a few hours the markets dismissed them, and by doing so repeated the same humiliation that was delivered to the BOJ, when it shifted to negative interest rates a few weeks ago.














This leaves the markets at a very dangerous crossroads. The central banks have lost control but the massive market distortions they created have hardly even begun to unwind.

These distortions are massive.

S&P 500 could be 60% inflated versus global equities

The header chart shows that until 2011 global equities ex-US, were very closely correlated with the S&P500. However, from that point on there has been a massive divergence, equating to around a 60% outperformance of US equities relative to the rest of the world, which is directly linked with central bank policies and interventions.

While there should always be some latitude for variations between different asset classes, for currency effects and other influences there is no convincing explanation for this degree of divergence.

The chart below demonstrates this with a different comparison, by looking at the S&P 500 relative to high yield bonds and leveraged loans. Once again we see the tight correlation until 2012, then a dramatic divergence in early 2013 which precisely coincides with the Fed’s twist and QE3 programs. This charts suggests that this distortion has inflated the S&P 500 by as much as 65%! Not far different from the scale of the distortion suggested by the parallel above with VEU, representing world equity markets!

S&P 500 could be 60% inflated versus High Yield Bonds


If you are still not convinced then the US equity rally should have been supported in some way by economic growth or earnings to validate the massive rally and outperformance.

Wrong on both counts.

Could the S&P 500 inflation be justified by economic growth? No.

Massive central bank liquidity is the more likely explanation. Nominal GDP growth in the US has continued to fall to the lowest levels since the 1930’s depression!









Could the S&P 500 inflation be justified by earnings? No.

Meanwhile there has been no growth in GAAP earnings since 2011!

Has the whole US equity rally since 2012 just been a spectacular achievement of engineering?

David Stockman explains:

“Markets are therefore unhinged from any connection to fundamental economic and financial reality, meaning that they are capable of an extended period of spasmodic deadcat bounces that will have only one end result.

Namely, the naïve and desperate among main street investors who still, unaccountably, frequent the casino will presently be taken out back and shot yet another time. The market technicians are pleased to call this “distribution”. Would that someone on Wall Street man-up and amend the phrase to read ” distribution…….of losses to the mullets” and be done with the charade.

The S&P 500 is heading through 1300 from above long before it ever again penetrates from below its old May 2015 high of 2130. And now that 97% of Q4 results are in, there is a single number that proves the case.

Reported LTM profits as of year-end 2015 stood at just $86.46 per S&P 500 share. That particular number is a flat-out bull killer. At a plausible PE multiple of 15X, it does indeed imply 1300 on the S&P 500 index.It also represents an 18% decline from peak S&P 500 reported earnings of$106 per share back in September 2014. And more importantly, it means that the robo-machines and hedge fund gamblers have traded the market back up to 23.1X earnings.

That’s off the charts…….except for when recession has already arrived unannounced by the hockey stick factories of Wall Street.”

Once again on these numbers we get an estimate of the S&P 500 that suggests that it is currently well over 50% too high!

What happens when there is an “earnings recession” with earnings below the TTM average?

And now earnings have fallen in to a recession below the TTM average. On every occasion previously that has meant a steep bear market as well as a recession.












Are any other asset classes distorted? How about gold?

If this still does convince you that markets are massively distorted then consider probably the most abused market of all which is gold. Below is the remarkable chart of gold deliverability, or positions relative to registered gold for delivery. Apparently, there is effectively no link any more between positions sizes and availability of physical gold!


It is unlikely that regulatory authorities are unaware of the fraudulent manipulation of bullion prices. The fact that nothing is done about it is an indication of the lawlessness that prevails in US financial markets.”

Paul Craig Roberts, Ph.D., is a former Assistant Secretary of the U.S. Treasury.

Dave Kranzler is a University of Chicago MBA and is an active participant in financial markets.


What is an investor to do?

So if we don’t know how valid current prices are, and not even the policy makers are clear what they can or will do next, how can anyone have a good idea about what the markets will do next?

The next question is what on earth should an investor do?

Here is the second best solution, after Cycle Dynamic Systems

The best solution I can think of is an approach that dynamically self-adjusts to evolving circumstances. This is what cycle dynamics systems does as discussed 2 weeks ago. Then there are other highly durable investment processes like Equity Buy/Write programs, which is what I discuss below. However, the risk management system must be very clearly and comprehensively worked out. Otherwise, there is still significant downside risk, even if it is already lower than for standard equity benchmarks.

Buy/Write Equity Portfolio
















The most important characteristic of long term successful investors is relentless pursuit of high probability return for minimal risk strategies.

One of the most successful of these strategies is to buy a solid equity exposure, or only the highest quality stocks and then sell (write) a call option on the same stock in the same amount. By doing this trade the pay off is converted from the straight blue line above, into the purple line.

Yes, the upside is now capped. However, the likelihood of a positive return has increased substantially. In the example shown in the chart above, unless the S & P 500 closes below 1275, the investor receives a positive return. Also the risk of the combined Buy – Write Strategy is much less than just owning the S & P 500.

In effect, the S & P 500 is fully hedged above a certain level and the hedge generates an income as the time value of the option expires. If there is in addition a very efficient loss mitigation system in the event of the S & P 500 falling much below 1275 then this becomes a high probability  return with very low risk.

An example demonstrates how this works:

Consider a trade I recently did:

Buy 100 T at 36.65,   T has an annual dividend yield of around 5%.

Then sell the April 15th 35 Call for 2.15. At the time the April 15th option was 2 months from expiry.

At expiry on April 15th the investor still owns T + time value of the option:

Time value is 2.15 – (36.65 – 35) = 0.5

So the profit from selling option was 0.5 / (36.65 -2.15)  = 1.4%

As this was a 2 month option the option can be bought back just before expiry and another 2 month option can be sold for a similar return.

So after a year the return is 5% dividend income from owning T, plus 6 x 1.4% = 5% + 8.4% = 13.4 %, all with very low risk. A very attractive, but very low risk return.

What is the risk?

On this occasion the smart stop was placed at 32.84. The actual loss would depend on when the stop is executed and the prices when the stop is executed. Assuming this takes place at expiry of the option. The loss would be

( – 36.65 + 32.8 +2.15)/ (36.65 – 2.15) = -1.7 / 34.5 = – 5%

Not only is this loss very unlikely, but the position is earning 13.4% per annum while it stands. So the loss will have already have been earned from income after just 4 1/2 months. So it is only a loss if it closes below the stop before 4 1/2 months have passed. Any loss diminishes over time as the position generates significant returns relative to the loss that would happen when it hits the stop loss level.

All this is before several other loss mitigation techniques are employed, to either further boost the yield or lower the risk or cost of loss. This can be consistently delivered through a dedicated stop loss software program.

Understand “market” distortions, understand risk, choose CD systems and equity buy/write allocations

Once investors fully realize how distorted and dangerous the markets have become, it becomes very clear that they need to rethink their whole approach to investing. These are the most challenging investment conditions I have seen in over 30 years of being a full time investment analyst. It is possible to not only survive, but also thrive, but only by choosing investment strategies that can manage the extraordinary conditions in today’s “markets”.

The best ideas I have are CD systems and Equity Buy/Write. There are some others I hope to write about, but investors need to understand that there is very little time to waste in making adjustments, as already central banks have begun to struggle with their absurd and now obviously failing experiments.




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