The Recent S&P Rally

The recent 25% upward move in the S&P500 from early March to last Friday is the subject of much debate. Unlike the similar gains in the index from mid-November to early January, this recent rally comes amid allegations that the economic news has stopped getting worse.

Using the aphorism that equity markets turn prior to the economy, many investors choose to believe that, if the pace of economic deterioration has lessened, that's good enough to justify piling into equities again.

Not so fast.

Several things about the current financial markets and economic situation cause my business partner and me to be unconvinced that there will be a sustained upsurge in the S&P that, upon being viewed in six months or so, will prove to be the beginning of a long run, healthy bull market in equities.

First, the contextual news regarding the consequences of deleveraging, as opposed to the recession, about which I wrote here in January, continues to be grim. Consumer revolving credit is becoming either more expensive, less available, or both.

Commercial real estate defaults are heralded to be worsening. Job losses continue apace.

We believe that much of this is deleveraging-related, not purely or merely caused by the recession and, thus, will not be revived anytime soon, federal leverage notwithstanding.

Second, the speed of the recent index recovery, absent strong fundamental corporate earnings data, or, for that matter, much of any other private-sector economic news of a positive nature, suggests a trading frenzy based on hope, rather than a longer term investment opportunity based upon early signs of a genuine economic revival.

Finally, the volatility of the equity markets remains distressingly high. Rather than decay in a 'normal' fashion, as equity volatility did after the crashes of 1929 and 1987, the most recent equity market crash has resulted in a uniquely sustained, high level of volatility. In fact, it has risen this year, both through the late-January decline, and the recent rally.

From our research, we believe it is very unlikely that this volatility will be associated with a healthy, sustained rise in equity market prices. Since we don't try to time the market, missing the 55% rise in the value of our March call options portfolio is acceptable.

In fact, the situation is reminiscent of a year ago. In 2008, there were three months in which call options had significantly positive returns for a long enough period to have been realized - February, March and April. May had briefer and lower levels of call returns.

Ironically, the put portfolio in May reached triple-digit returns, but much later, i.e., after the September equity market carnage. April's puts attained near-triple-digit returns near the end of their lives.

The moral of this story is that, occasionally, one side of the derivatives positions of our portfolios will peak very early, while the other achieves much higher returns much later. In a turbulent market, this is not unheard of.

We think that's what we are seeing again in the current equity markets. Near term hope driving modest equity and call returns, while longer term puts will likely have higher returns later this summer.