Here are some articles of interest we found this weekend.  Subscribers, make sure you’re logged in and check out our weekend portfolio update. Also, warning: information and ruminations dealing with ethics, justice, and good governance ahead, so stop reading if you are allergic to any of those things.

• Michael Greenberger is the most cogent defender of the view that the recent parabolic move in oil prices is due largely to structural factors enabling manipulative speculation.  In this episode of The Disciplined Investor podcast, he explains his position.  Video of Greenberger’s testimony before the Senate Commerce Committee.
• Andrew Horowitz follows up with some comments of his own, noting that the Enron Loophole (the purported enabler of this price manipulation) was opened in 2000 by then Senator Phil Gramm.  Gramm has also been linked to the late 1990s round of banking deregulation that made the subprime crisis possible, and then as a vice-chairman at UBS used his political contacts to roll back restrictions on predatory lending.  Gramm now serves as the general co-chairman of one of the current presidential campaigns.  Still.  Even after all of these revelations have come out.
• Seymour Hersh, one of the greatest investigative journalists alive today, has an extremely important piece about ongoing American intelligence and destabilization efforts in Iran.  One of the most disturbing revelations here is that the CIA is funding and supporting radical groups with links to al Qaeda:
  

  The Administration may have been willing to rely on dissident organizations in Iran even when there was reason to believe that the groups had operated against American interests in the past. The use of Baluchi elements, for example, is problematic, Robert Baer, a former C.I.A. clandestine officer who worked for nearly two decades in South Asia and the Middle East, told me. “The Baluchis are Sunni fundamentalists who hate the regime in Tehran, but you can also describe them as Al Qaeda,” Baer told me. “These are guys who cut off the heads of nonbelievers—in this case, it’s Shiite Iranians. The irony is that we’re once again working with Sunni fundamentalists, just as we did in Afghanistan in the nineteen-eighties.” Ramzi Yousef, who was convicted for his role in the 1993 bombing of the World Trade Center, and Khalid Sheikh Mohammed, who is considered one of the leading planners of the September 11th attacks, are Baluchi Sunni fundamentalists. [our emphasis]

• Let’s pause for a quick syllogism.  Call it a reductio ad absurdum of contemporary US national security policy, on two counts.
  

  (1) If a government actively supports al Qaeda, the United States should depose that government by force. (premise, per the “Bush doctrine”)
  (2) In 2003, Iraq was actively supporting al Qaeda. (premise, per smoke and mirrors)
  (3) Therefore, the United States should have deposed the government of Iraq. (1, 2, modus ponens)

  As problematic as it may be, let’s grant (1) for the moment. Now, we know that this argument is unsound, since (2) was always false. But we can replace (2) and run the argument again:

  (1) If a government actively supports al Qaeda, the United States should depose that government by force. (premise, per Bush doctrine)
  (4) In 2008, the government of the United States is actively supporting al Qaeda. (premise, per Hersh)
  (5) Therefore, the United States should depose the government of the United States. (1, 4, modus ponens)

  The two counts, in case it isn’t clear, are a) that “al Qaeda” is and always was an ambiguous term, such that basing military invasions on connections with the same is/was a weird idea; b) the US should quit supporting fundamentalists in its bid to quash fundamentalists.  You’d think we would’ve learned our lesson in Afghanistan.

• James Gustave Speth in Barron’s offers some ideas for evolving a less environmentally destructive version of capitalism.  He concedes that this would entail slower or no growth, but rejects the implicit premise that GDP = human well being (as we have discussed previously), which means that an economy focused on improving human society, rather than just infinite meaningless expansion, might not be a bad thing at all.

Neither of the scenarios outlined in yesterday’s Update materialized today. While the Dow was down more than 150 points at its lowest, EEM held yesterday’s low and appears to be headed for a close above$134. On the other hand, implied volatility remains near yesterday’s close/high, failing to give us the break we would’ve liked in order to buy a second July calendar spread. Nevertheless, we’ve found a July/August calendar spread that looks like a reasonably good trade.

The Thesis

At our limit price of $1.15, the IYR July/August 61 put spread has break-evens near support in the $58–$59 range and down-trend resistance at $64. And because strikes are $1 apart, we’ll have lots of flexibility if we have to adjust.

The Trade

We’re opening the following Calendar Options position for July expiration:

+4 IYR August 61 put
-4 IYR July 61 put
for a net debit of $1.15.

Our break-even points are at $58.10 and $64.10. Our initial delta is essentially neutral.

Remember that we need at least 4 contracts per leg when we open a single-calendar trade, so we can split our position twice if necessary.

On a day like this, you really need to start off any post with some good news.  Apparently, one of the greatest television shows of our time might be made into a movie: we’re talking about Arrested Development.  So you see, there is hope for this country after all.  (Nevermind that we’re all so scared of the boogeyman that the government will be warrantlessly watching the movie over our shoulders; that’s a matter for another day.)

Okay, now to the issue at hand.  Markets gapped down at the open and never looked back, closing at the lows on higher volume.  Severe technical damage has been done to the indexes on a short and long term basis.  Key support levels from March 07, January 08, and March 08 should have held the selling in check, but the bears blew right through those lows.  This was a high volume, high intensity day in which no buyers ever really stepped up.  We kept hearing things throughout the day like, “Where are all the value investors?”  Off acting like Milford men, that’s where.

Before the open this morning, we sent a note to subscribers describing why we were still in full bearish mode:

Our opinion is still that we are in the midst of a bear market and that any rallies will be short-lived and indecisive.  Some market commentators (especially in the rah-rah corporate media) have been calling for another rally like the one we saw off the March lows.  The primary reason we reject this view is that the sectors that provided leadership during the March rally (tech, transports, energy) now appear overextended - or at least weakened - and we haven’t seen any new leaders emerge…

More importantly, we said that this was as good a time as any to tighten up those allocations and double-check your risk tolerance:

One other important point here is that this is a good time to double-check the allocations you’re working with.  This applies not just to our newsletter trades, but to your whole portfolio.  Revisit each open position, and ask yourself whether you would be comfortable if you ended up exiting that individual position for a 50% or even a 100% loss.  If the answer is no, then dial down your allocation.

Today was a perfect example of why we prefer to trade spreads on ETF options instead of the traditional big index products.  SPY quoted contracts a few pennies apart today, which is typical, while you could catch similar SPX strikes at a dollar and a half wide or more.  Good luck getting a fast and fair exit in the SPX pit on a day like today.

Where do we go from here?

The first thing to say is that action like this is not to be blown off - even if we bounce up 200 Dow points over the next couple trading days, that wouldn’t negate the horrible market internals and total lack of support we’re seeing now.  That said, here are some factors that may favor a snapback sooner rather than later:

• $SPXA50R - the percentage of S&P 500 stocks above their 50 day moving average has been a helpful tool in the past for discerning market tops and bottoms.  Over the past four years, on the five occasions when this indicator has been at 20 or below, the S&P 500 has been significantly higher in the weeks following.  Now that it is fashionable once again to disparage technical analysis, we’ll note that this particular indicator is actually quasi-fundamental: when too many high quality stocks are irrationally sold off, value-chasing buyers invariably step in to snap them up, and that tide lifts even the less seaworthy boats.  Click on the chart for a full view.
• RSI(14) - this is the old standby, the 14 period Relative Strength Index.  Going back to 1999, there are only about 15 occasions when the RSI(14) has fallen to 30 on the SPX daily chart.  When that happens, the index is almost invariably higher the following week(s).  One interesting, if unsettling caveat is the fact even a slow-moving indicator like this can get oversold and stay oversold through a pretty nasty fall, as happened twice in 2001 and once in 2002.  Even so, unless we’re in the middle of a slow motion market crash, the odds still seem to favor some moderation in the near future.
• $VIX - normally, this is the part where we comment on some beautiful VIX spike and how investor fear has gotten really overblown. But the story here is actually the relative complacency in implied volatility.  Not sure exactly what’s going on there, expect that in all likelihood the smart money has been putting on robust hedges for weeks now.  This is also a data point in favor of not using VIX options as a proxy for regular index price movement - there’s absolutely no guarantee of any 1:1 relationship.  But anyway, what do we make of the conventional wisdom that you can’t get a market bottom without a VIX spike?  Who knows?  (Well, our future selves of 3-4 weeks from now know, that’s who.)

One last thing.  If your portfolio got hammered today and you’re looking to rebalance, don’t kill all of the positive theta trades you have going by throwing in the towel and loading up on expensive puts.  If you want to get in on this trend, sell some OTM index call spreads; if you’re an uber-contrarian, sell some not-so-OTM put spreads.

The July cycle so far has largely been a waiting game for our Calendar Options strategy. We wanted to wait until we’d closed out at least some of our June positions before opening our first July calendar spread. Then came a nasty expiration day, followed by the period of uncertainty heading into the Fed’s two-day FOMC meeting.

Today we again find ourselves sitting on our hands. We’d planned to open a second July calendar spread this morning, after the dust had settled post-Fed, but we got a dust storm instead. Sometimes the best way to trade is not to trade.

Nevertheless, it would be nice to balance the 48 delta of our EEM July/Sept 140 put position with another trade that has zero or negative delta, so if things settle down tomorrow we’ll be looking to open a bearish-to-neutral July/August calendar spread. But if the sell-off continues, we’ll have to focus on managing our risk by adjusting our EEM position ahead of the weekend.

The clamor over whether “speculators” are driving oil’s parabolic run-up has become almost deafening, with the number of Congressional hearings on the subject reaching 40 this week and the price of oil dominating the nightly news. For every market analyst making the case for a speculative frenzy, the media have found an industry expert to argue that high oil prices are justified by the underlying supply–demand imbalance and weak dollar. If this sounds familiar, it might be because the scenario looked quite similar when the housing bubble came to a head.

Way back in 2005 when the Philadelphia Housing Index peaked. . .no, make that 2006 when it took a major hit. . .er, wait,. . .2007 when it fell 50% from its January high—the National Association of Realtors and the National Association of Homebuilders still refused to admit that current home prices were unsustainable. The real estate bubble was due partly to low mortgage rates, partly to speculation, and mostly to buyers’ fear that if they didn’t buy now, they’d have to pay more later—but it took months of housing declines before the “experts” would admit that things weren’t exactly hunky-dory.

Yet the future was crystal-clear to anyone looking at the chart on the left. The Japanese stock market in the late 1980s (black line) defined modern bubblology, and the tech bubble (blue line) carved out a paragon of the hyperbolic spike. By the time real estate (green) had traced the same vertiginous ascent, the writing was on the wall.

Now the price chart for oil (red) is looking eerily familiar. Ignore the fact that oil appears to be peaking at the same level as its predecessors—each plot is scaled to the vertical dimension of the chart—but note the rate of ascent over the past year. That vertical wall is the scarlet ‘B’ that flashes “bubble” in ten-foot neon lights.

One of the most credible arguments against the speculation theory comes from Daniel Yergen, “one of the nation’s best-known energy experts,” according to the New York Times. A Times article yesterday focusing on Mr. Yergen’s expected testimony before Congress summarizes his position as follows:

As the ninth hearing of the month gets under way on Wednesday, . . .Daniel Yergin, is expected to tell Congress that the focus on speculation is largely misguided.

Mr. Yergin will join numerous other energy experts who have declared that the rise in oil prices can be explained by basic economic factors, such as the limited growth in supplies in recent years, a weakening dollar, a global surge in energy demand and a string of production disruptions in countries like Nigeria.

Buy wait—there’s more:

Mr. Yergin said the market is relentlessly bidding up oil prices in response to deep-seated fears that the growth in demand will keep outpacing the growth in oil supplies in coming years.

“There is a shortage psychology in the financial markets and that is reflected in the price of oil,” Mr. Yergin said in the interview. “You are seeing a lot of people who have never invested in commodities who are now piling into the market. But calling it speculation is way too simplistic.”

Notice that Yergin doesn’t just overlook the bubbly nature of current oil prices—he actually confirms it, with phrases like “deep-seated fears” and “shortage psychology in the financial markets.” And he doesn’t even touch on forces like the automotive manufacturers’ fixed-price gasoline offers, which must be pumping a huge amount of money (temporarily) into the futures market as these companies hedge their incentives.

But it’s two additional developments that put us over the top. For contrarians, there’s the premier of the cable-TV reality show Black Gold. And for the politically focused, there’s the Republicans’ no-holds-barred drive for legislation permitting oil drilling in previously prohibited off-shore locations, including the Arctic National Wildlife Refuge—heedless of the fact that it would take ten years to have any impact, and that this impact would be minuscule.

Granted, there’s no way to know when the oil bubble will burst. Also granted that the fundamentals do support a certain price that’s above where consumers would like it to be. And yes, the dollar’s weakness is reflected in the price of oil. Unlike the Nikkei, tech, and housing, however, this bubble is likely to deflate only partly, before resuming its climb until alternatives displace oil as our primary energy sources

Position in United States Oil Fund (USO).