Excerpts from Artemis Capital's Q4 2010 Report - Excellent reading.

• 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 volatility premium into risk assets by the investor class (JPM, Goldman etc) 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.
• Volatility aberrations observed during the fourth quarter may be bad omens that asset prices are overly dependent on government stimulus. Below is a list of volatility anomalies recorded since the introduction of the second round of fiscal and monetary stimulus:
• The market registered some of the largest drawdowns in the history of S&P 500 realized vol dating back to 1950
•  The spread between the VIX index and 21 day realized volatility (and respective volatility of volatility) is at the widest levels in history
•  The differential between S&P 500 realized volatility and 10-year US treasury % yield volatility is at the lowest level in history
•  An incredible 7 of the largest 50 drawups in 10-year UST yields (as a percentage) since 1962 occurred in Q4 2010

Tranquilizing the Economy - Lessons from the Zoo

A good friend of mine from college is now is a wildlife veterinarian at a major metropolitan zoo. One of her first assignments during her residency was to dart a sick elephant with a tranquilizer gun so she could safely provide medical treatment to the animal. This is every bit as difficult as it sounds. Each load of tranquilizer for a full size elephant costs $20k+ so it is very expensive to miss your target. If you hit the elephant but don't use the correct dosage you could have either an overly violent or comatose giant mammal on your hands. It is important for the vet to understand when the elephant is properly sedated and how long the before the effects of the drug wears off or she puts herself at risk. My friend is a very competent wildlife veterinarian and I guarantee she would never be stupid enough to mistake a tranquilized elephant for one exhibiting normal behavior.

Oddly when it comes to the economy many talking heads are not smart enough to differentiate between a healthy financial system and one sedated by unprecedented amounts of stimulus. This is not to say that a certain amount of cautious optimism isn't warranted. As they say you don't fight the Fed.

  In a November 4 op-ed piece in the Washington Post Fed Chairman Ben Bernanke explicitly stated that higher equity prices were at the forefront of the quantitative easing program adding that"higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending." After reading the article I was shocked at how candid he was about his intentions to prop up the stock market with printed money. Mission accomplished! Not withstanding at some point this elephant of an economy will awake from this stimulus induced slumber and those who are none the wiser may get trampled. Talk about animal spirits!

• Interesting to note is that 2010 was the #1 ranked year for volatility drawdowns in history with an average vol drawdown of -8.84% lasting just over 2 business days.
• Consider the fact that the ten consecutive days of declining SPX realized volatility (21 day) ending on November 3rd was the third longest observation since 1950! November's -41% decline in vol was followed by a -56% decline lasting 8 days ending on January 4, 2010. On a percentage basis these negative declines ranked #29 and #10 out of 3778 total drawdowns dating back to 1950.
• The incongruity between the VIX premium and the VOV premium is a contradiction in the volatility regime that is very rare historically. Keep in mind there is an arbitrage between implied volatility and statistical volatility and when spreads remain historically wide it is a lost profit opportunity for Wall Street. Despite this fact the VIX index refuses to budge because traders think there is serious risk volatility will go higher. So which indicator is correct? I took the liberty of ranking other periods in history whereby there has been a high VIX premium to VOV ratio. Observations since the implementation of QE2 dominate the top ten ranked observations. Other key periods include early 2001, late 2006, and one month before the Flash Crash in April 2010. We can conclude that high levels of volatility premium in conjunction with lower volatility of volatility ratios are a sign that near-term volatility is close to a bottom.
• Incredibly 7 of the largest 50 percentage drawups in 10-year US Treasury yields since 1962 have occurred in the last three months! In other words 14% of the largest upward % movements in 10-year UST yields over 48 years happened immediately after the Fed starting buying bonds with the intention of pushing down yields
• The current regime of monetary and fiscal stimulus is similar to writing a naked put on the entire financial system with margin backed by the US debt. The premium received from the sale of the naked put is financed via demand for our debt and redistributed to the investor class to re-flate underlying asset prices and depress volatility. The theory is that the reinvestment of this premium by investors into underling risk assets ensures the Fed's naked put is never exercised. In effect, the Federal Reserve is constantly shorting vega on a systematic level. This stimulus regime socializes "tail risk" to generate short-term prosperity. If asset prices drop the Fed is forced to sell more volatility to artificially support prices. This will work as long as (1) asset prices do not collapse too far or; (2) taxpayer funded margin is unlimited. If either of these two conditions are not met the asymmetrical return distribution of the strategy will result in complete ruin.
• The Fed's massive volatility short is highly dependent on the concept that the taxpayer monies backing the trade can be increased exponentially as needed. This is why the Federal Reserve is now the world's largest holder of US Treasury debt at over $1 trillion (China is now #2). Unbeknownst the average US taxpayer is backstopping a massive leveraged sale of economic volatility. Every year the incremental premium received for the sale of volatility gets smaller and smaller while the taxpayer margin required to fund it grows exponentially. met the asymmetrical return distribution of the strategy will result in complete ruin. It is a martingale process, similar to constantly doubling down your bet while gambling (with better odds though). It works only if your bankroll is unlimited.
• With the US debt already approaching 100% of GDP there may be no more available leverage capacity for the Fed to continue selling volatility. It is highly ironic that the monetary strategies used to bail-out Long Term Capital Management are now dangerously similar to the martingale based models that caused famously doomed hedge fund to self-destruct. In effect the health of the global economy now hinges on one exponentially margined short volatility trade.

A Contrarian idea in conclusion

The current disparity between bullish euphoria and long-term systematic risk could represent one of the best volatility tail-risk hedging opportunities since the first half of 2007. Artemis is currently looking to increase our long-term volatility hedges within the disciplined framework of our quantitative models. With this in mind the long-end of the volatility term-structure remains historically steep. For example, the VIX options market has priced in an estimated 98% probability the VIX will rise by May 2011 with a probable range between 16.83 and 35.96 (according to model-free volatility pricing across the strike spectrum). Despite this fact value can be found in select maturities of out-of-the-money VIX calls that are attractive on a risk-to-reward basis given the current macro-risk environment. In addition, individual investors may also buy tail-risk in the form of S&P 500 LEAPS that provide protection out to 2012 at volatility levels that are only 1-3% above historic averages. Although it probable the VIX index will remain range bound between 17-25 throughout the first quarter of 2011 there are enough potential risk factors to warrant both the steeper than average volatility skew and the incremental investment in tail risk.