Leverage, Weekly Wrap 10/22-28/2017

Macro and Markets

The last weekly wrap featured a flag breakout pattern in the Russell which fell back into the consolidation channel earlier in the week. My own portfolio is highly leveraged to the NDX so I went into Thursday with plenty of angst. Fortunately they didn’t disappoint. The Christmas rally is now in “full on” mode. Naturally big tech earnings will be fingered as the proximate cause but I believe money coming out of the bond market will provide the more sustained fuel. The last time I showed the 10 year yield ($TNX/10) it was sitting at the recent low of 2.03%. It has since shot up to 2.43%, a huge move. I expect it to reach 2.8% in the first half of next year and eventually over 3% to force investors who have been piling into bond funds to switch into stocks, setting the stage for the final bubble mania.

Below is the ratio of the Energy ETF ($XLE) to the price of Wester Texas Intermediate. The ratio has dropped below support as energy stocks stagnated while crude price advanced on supply cuts. $XLE just tested its 200 DMA and has the potential to get back to $73-75. I continue to monitor this space for an opportune time to unload my Exxon and Chevron.

There were a number of important geopolitical events this week. Abe won convincingly again which means BOJ will maintain its loose monetary policy (~$50bn per month?). Draghi announced a “dovish taper” of €30 bn per month to at least Sep’18 (note combined they are greater than the projected $50 bn Fed balance sheet reduction, before anything from the PBoC). Xi JingPing consolidated his power — I’ve never worried about the Chinese debt, much less so after this expected development. The final solution for any debt problem is some kind of equity/debt swap which only a country like China can successfully pull off. Congress is likely to expand CFIUS review (source). As far as seed-stage tech investing is concerned I can see how this can backfire. Chinese VCs will simply ask early-stage start-ups to move to China — in ZhongGuanCun, they work harder and for less. The market and users are there, so why not?

Gold

Gold price movement is unfolding as laid out last week. Next significant bounce may occur at the 200 DMA ($1260) around the next FOMC meeting (Oct 30 – Nov 1). The bounce will likely fail.

Portfolio

Despite the movement in rates noted above, many Pimco multi-strategy CEFs gained in NAV, i.e. they have negative effective duration. I added to PCI. Muni CEFs are under pressure but I believe their distributions are safe and will continue to hold/add. I added to Tencent ($TCEHY) to bring its weight in-line with other tech stocks.

A portfolio allocation breakdown can be found in the annual review in July. There has been some changes since then: PMs have dropped to 10%, equities increased to 58%, fixed income slightly lower at 23%, and the “Other” category more than doubled to almost 5%. The “Other” category has three components: cryptocurrencies (2.5%), 3x leveraged ETFs (1.1%), and options (0.9%). The market value of the options is quite deceiving. As of Friday, the total delta times the underlying equals about 55% of the total portfolio. In other words, there is a leverage ratio of 55-60X on the current market value. I expect the delta to increase due to positive gamma; as I move up the strike of the puts I use some of the gains to buy more calls. This level of leverage is possible with futures. However I like the liquidity of QQQ options vs. NQ, I also plan to get long term capital gain rates instead of the 60/40 split of section 1256 contracts.

I have debated whether to reveal the exact option trades but have decided not to, at least at this time. The basic mechanics have already been discussed in this blog. Basically, naked puts were sold to finance calls, and a million variations on that theme. All transactions were for credit, i.e. there was no cash outlay to build up these positions. There is margin impact for selling naked puts for sure. At IB where I have portfolio margin, it’s 10% of the max loss or assuming the underlying drops to zero. On that basis, the leverage ratio is about 13X. Note margin impact is not the same as margin balance. I don’t buy on margin or pay any margin interests.

The main reason for not revealing my exact option trades is that they’re of little use to the readers. First, I don’t expect many to have the level of trading authorization to sell naked puts. Second, the right time to put on those exact positions was before the market took off. I started at the of June. Last but not least, it takes a tremendous amount of conviction to with them. Following someone else blindly into a trade is just about the worst thing one can do.

Good Reads

None of the above is investment advice, the standard disclaimer applies.