Up until last week, I was relatively sanguine regarding the debt ceiling standoff in the US and the prospects for volatility tied to a potential sovereign debt default. I was not necessarily bullish about what sort of deal would be worked out amongst the politicians. However, my base case was simply that it was highly likely the politicians would do just enough for the country to get by. Indeed, I believed that there were some positive developments last week that seemed to be moving things in a positive direction.However, in the past five days, new information has come to light that I believe has considerably increased uncertainty regarding the prospects for a US default and/or downgrade. The new circumstances raise a fundamental question: Given the risks involved, do you really need to be invested right now? Calculating Expected Returns in the Context of Increasingly Incalculable RisksThe current political standoff over the debt ceiling in the US presents four main scenarios, which could interact in various ways:
Making a good investment decision in the current environment would involve estimating a return for each possible scenario and then assigning a probability to them. The weighted average of risks and returns times their probability equals “expected return.” Explicitly or implicitly, “expected return” is the foundation for all rational investment decisions. But in this particular case, how do you assign potential returns and probabilities to each of these scenarios? It is my belief that in this particular case, the enormous range of possible outcomes make any calculation of expected return highly unreliable. I can find no rational basis for taking positions in the equity market at this time. ConclusionInvestors are understandably perplexed about what to make of this unprecedented and confusing situation surrounding the political impasse and the possibility of default. If you are one of these people that are fretting about what to do, I have a reminder for you: You don’t have to play. If you think that you have an edge, or some sort of relatively unique insight as to what will occur in the next few days and weeks, be my guest. Personally, I have concluded that I do not have an edge with regard to how the debt ceiling debate will be resolved and how a downgrade will be averted. I have therefore decided that I will watch this drama from the sidelines and stay there until such time as I believe that I have regained an edge. Yesterday I sold all long equity holdings in my portfolio and am overwhelmingly in cash. Below, I describe my only exposures. I retain my short treasury position. I retain some low value out-of-the-money puts on SPDR Gold Shares (GLD) and Market Vectors Gold Miners ETF (GDX). I have made a small S&P put purchase. Why? Although I believe that risk of default is low, with the market near recent highs, the risk to the downside is asymmetrical. In this context I believe that the implied volatility of put options are too low, making the price of put contracts attractive. Finally, due to the fact that I think implied volatilities are too low and will tend to rise, I have purchased some iPath S&P 500 VIX Short-Term Futures ETN (VXX). If a reasonable deal on the debt ceiling is reached, many of the stocks I sold such as Apple (AAPL) and Financial Select Sector SPDR (XLF) should rally significantly. However, this “missed opportunity” is an “opportunity cost” that I am happy to assume. I repeat: If you don’t have an edge, why play?
Most Read
Emailed
Latest
Read Full Article »