Note: The following article is an excerpt from the Fourth Quarter 2010 Letter to Investors from Artemis Capital Management LLC published on January 4, 2011. PDF Download
In the eyes of this volatility trader the current paradigm of monetary and fiscal stimulus may best be understood as the greatest leveraged volatility short in economic history. The current stimulus program is analogous to continuously rolling “naked” put options on the global economy, backed by margin provided by the US taxpayer, generating short-term growth at the expense of long-term systematic risk. The reinvestment of the vol premium into risk assets by the investor class ensures the Fed’s naked put is not exercised. Although policy makers have been rolling the great vega short for the past 30 years it has never been more levered than today. At present bullishness is pervasive as the government has succeeded in artificially suppressing asset volatility with the new stimulus. To be fair the economy is improving with corporate profits increasing for seven consecutive quarters and credit spreads narrowing. Many economists are revising their 2011 GDP projections upward. Nobody should be afraid to attend this stimulus party or the fledging recovery but before agreeing to ride home on the risk bandwagon I’d prefer to make sure there is a designated driver. In the future we may look back at this period of unanimous euphoria as the best opportunity since mid-2007 to purchase ‘tail risk’ insurance in the form of long-dated volatility.
In Q4 2010 the volatility markets were fully sedated by a massive dose of fiscal and monetary methadone. In the wake of weakening economic data this summer and near 10% unemployment the US government wasted no time in applying new rounds of stimulus.
Immediately prior to the start of the quarter the Federal Reserve signaled its intention to renew its Treasury bond purchase program and subsequently purchased $168 billion of debt on route to a planned $600 billion total by the end of June 2011. In November the Fed passed China as #1 largest holder of US Treasury Bonds and now has $1.2 trillion of holdings as of December
Not to be outdone Congress piled on its own supply side stimulus in a bi-partisan “compromise of excess” by extending the Bush era tax cuts for all classes, providing a payroll tax cut, and extending unemployment benefits. This should increase the deficit by approximately $900 billion over the next two years. Government liabilities have expanded over $4 trillion in nine quarters.