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December's bull talk that 2011 would be great for investors is running out of steam a few weeks into January.
So far, earnings results are mostly falling short of the sell-side hype. J.P. Morgan's Tom Lee, the equity strategist, told clients Friday that earnings-per-share reports that beat estimates are coming in at 68%, below the past four-quarter average of 74%.
These are the early days of earnings season, but it is hard to ignore what is happening in the financial sector. That would be the sector that, just a few weeks ago, investment-bank bulls said was poised to carry the stock market higher, due to improving consumer spending, fewer credit defaults and all sorts of other data that analysts monitor.
Yet Citigroup (ticker: C) reported crummy results. Everyone in the options market was betting that the stinky stock's earnings would push it permanently past $5. Instead the earnings data dunked the stock below that mark, making it untouchable to many major investors whose investment charters prohibit them from owning stocks below $5.
EVEN MIGHTY GOLDMAN SACHS (GS) took a hit. The wonder boys missed their revenue estimate, which often bodes poorly for others. If Goldman has a hard time making money—and Goldman is the market—imagine what that means for everyone else.
No one really has to imagine too much, thanks to Bank of America (BAC), viewed by many top traders as always in the wrong place at the wrong time. The megabank's fourth-quarter loss widened to $1.2 billion from $124 million a year earlier.
A senior executive at a top exchange—who must stay anonymous as ours was a private talk—said he noticed a distinct lack of the trading waves in exchange markets that usually are generated in response to big action on private-trading networks. The executive said that decrease could foretell difficulties not yet widely recognized.
"Are woodland creatures seeking higher ground in front of a tsunami? Or do we buy this dip?" J.P. Morgan's Lee asked clients in a Friday note. He wants to buy the dip, which makes good sense provided that investors protect portfolios with options that will increase in value if the Chicago Board Options Exchange's Volatility Index (VIX), recently at about 18, spikes higher.
ONE SELDOM-DISCUSSED REALITY of the modern options market is that the computers that control pricing models sometimes get out of tune with market reality. As stocks grind higher, as occurred in the fourth quarter, the models anticipate lower implied volatility because stock prices have advanced in the past. The past few days saw institutional investors buying bearish puts to protect against a decline, but the action wasn't significant enough to cause a rapid increase in implied volatility.
A lesson of the past year is that wise investors buy volatility when it seems too low, and sell when it is too high. The volatility metronome also works for timing stock trades.
Risk premiums, as measured by the Chicago Board Options Exchange Volatility Index, are too low now, given the cross-currents roiling the surface of the stock market. This typically marks a good time to buy defensive index options to hedge against broad-market declines and volatility spikes.
With VIX around 18, Jim Strugger, MKM Partners' derivatives strategist, is telling clients to buy VIX Feb. 21 calls and sell VIX Feb. 30 calls to protect against an earnings-season volatility spike that could temporarily interrupt the bull advance.
"After being bullish on equities since late August, and riding this volatility wave lower, we're saying, 'get ready for a VIX spike to 30,' " Strugger says.
Comments: steve.sears@barrons.com
http://twitter.com/smsearsBarrons
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