From the Archive: Small-C March 2009 Letter

The portfolio returned 3.5% for the month, bringing our year-to-date return to +6.7%.nbsp; Much of the action took place the week of March 16^th, when the US Federal Reserve announced its plan to begin buying treasuries.  It was a moment we had been salivating over all year.  Yields (though not spreads so much) on our corporate bonds squeezed lower, gold and crude moved up, and we were presented with precisely the moment we were waiting for to short treasuries.  Sterling corporate bonds, though, still didn’t perform much over the month which is starting to bother us.  The S&P trended upward, but more slowly than Asia-related equities, and failed to breach the boundaries of the wide strangle we sold, while implied volatilities moved down.  So nearly everything in the book was working.  And that meant that even the best moments were pretty boring - the natural result of our decision to pursue safe yield over the year.  It was one of those months where we wished we had made bigger bets.

We made three trades during the month.  We sold puts on the S&P at 600, we incrementally increased our S&P short at 830, and we went short long-dated treasuries.  We feel the book couldn’t be much better-positioned, which brings an interesting conundrum: if a book is well-positioned for likely future scenarios, it shouldn’t need adjustment.  But clearly the world changes every day, so shouldn’t that necessitate constant adjustment?  Whatever.nbsp; Frequent adjustment is costly enough from transaction and tax standpoints that we prefer to believe it’s not important.

Over the month of April, we will look to add to our equity short if the bear-market rally continues.  We’re not technicians, but the 830 S&P level is important to us because of the Other January Effect we have written about before.  We will also be thinking about how to add a bit of leverage to the book - the cash position is currently more conservative than we would wish.  With any luck, implied volatilities will increase to the point where we can sell options again; so far we have maintained a disciplined approach to selling volatility only when it looks expensive and it has paid off.

For those of you who are asking how big the bets are, we came up with the following representation of our positioning.  A traditional portfolio manager would tend to think of the book like the first column, at option delta.  However, since we do not hedge option positions dynamically and intend to hold them to maturity, we think about options as if we had the entire exposure invested, the second column.  This illustrates that our book is a bit short equities today (though long beta), but becomes long equities in the future if the price becomes more reasonable, while being long fixed income instruments and inflation - but roughly neutral rates (the duration of the net position should be low-ish).

We have no clueas to when to cut or increase our commodities exposures and so will probably hold them for a year to gain the tax benefit.

Mob rule continues.  The American Congress debated, though did not pass, a bill that would tax executive bonuses at 90%.  Congress also called on financial services companies to release names of individuals who had been granted bonuses in 2008, an act seemingly in violation of employees’ confidentiality, and one which could, quite literally, endanger those individuals to action by lynch mobs.  President Obama stated on television that he believes US citizens should pursue productive professions like engineering, not finance, though he refrained from endorsing Congress’ 90% bonus tax.  Do these facts make you feel inclined to invest in the US as a stable, democratic country, ruled by law?  Us neither.  Perhaps the reality will prove to be less biting than the rhetoric.  Some of what President Obama says, like a statement that "auto companies will not become wards of the state" is quite sensible, while other things like "from this day forward, your US car warranty is guaranteed by the US government" are just off the wall.  These are just small flotsam that we happened to pick out of the politico-financial maelstrom swirling through the media this month but much of it sounds similar.

One thing we are sure of is that as long as politicians continue to erode freedom in the markets and stand in the way of reconstruction, as long as the media focuses on finance, and as long as commentators pine for a return to "normality", there will be no durable rebound in asset valuations.