It has been a crazy week to say the least. In the past few days we have seen China outlaw the selling of stock, Greece outlawed common sense and technical glitches were everywhere. In a non-ZIRP world, a state I like to call reality, yesterdays events would have triggered a tsunami of selling. Instead we dropped less than 2% in the S&P 500 and we are trying to gain a portion of that back today. The markets quite simply are crazy right now. Crazy has to equal cautious when you are just 3% of all time high. If we were 3% off the lows of the 3 year lows crazy might be a good time for throwing caution to the wind but that’s not the case here.

Tobias Carlisle tweeted out a chart today that showed the historical EV/EBITDA ratio of the S&P 500. On his excellent web site www.greenbackd.com he said “I like to check in occasionally to see where the S&P500’s average enterprise multiple stands. Right now it’s trading on just over 12x, where it’s been since the start of the year. It’s rarely been this expensive. Indeed, the average for the full period is 10.4, and it’s only exceeded this level in the late 1990s and briefly in the early-2000s.” t is not a precise measure to be sure and not a timing mechanism but it does tell me that stocks are not cheap. We can argue all day about it being fully or overvalued but we cannot even begin to talk about the market being cheap. I am much more comfortable missing the last few percentage points of an aging bull than I am taking the full ride to the bottom.

It has been a crazy week for the Melvin Clan as well. My daughter is now a Chicagoan as she and her husband have taken up residence in the windy city. I am delighted by this because when she feel those first winter winds off the lake in December I think we will see a lot more of here in the winter of 2015-16. When she figures out she can fly here for a couple of hundred bucks and not have to dress like a homeless eskimo just to run out to Starbucks Dads house in sunny Florida is going to be a popular destination. The fact that I love Chicago and can use visiting the daughter and son in law as a reason to take them bar hopping on Rush street with my old degenerate options and futures buddies factors into that a tiny bit as well.

The other big story is that the wife and youngest have taken off for her annual jaunt to Texas to see her father and siblings. I would have loved to have tagged along as Rockport, Texas is one of my favorite little towns on the planet and we had considered moving there before we came to Florida. The town is three hours or more from anymore and reminds me a great deal of the west coast of Florida in the late 1970s. A lot of the boats you see are working fishing boats, they still have a shrimp fleet, there are waterfront bars where you can eat and drink without a second mortgage, dive bars and a great mix of dining choices ranging from fish to Mexican food and of course the all-time Texas classic and Tim favorite, Chicken Fried Steak. I would love to have gone and enjoyed the beaches, dive bars and fishing but it is just impossible to get anything done when I am there. My Father in Law has a great house on a canal looking out over the bay but the internet and cell reception, to put it kindly, suck.

With kids, cousins, nieces, nephews and neighbors running in and out and everyone wanting to go here and there I am generally just in the way as I sit around cursing the reception and trying to monitor portfolios, get articles written and fielding calls and emails. The crack staff and I stayed home again this year and while I have a pile of books and a bunch of testing and number crunching as well as an excess of baseball to keep me busy you can plainly see that the dog is not that pleased that her favorite people are gone and she is left with just the feeder and poop scooper for company:

Among the numbers I will be crunching this week is a complete look at the arcane practice of closed end fund arbitrage. Its not a true arbitrage as its difficult to sell short a whole portfolio of stocks or binds against a discounted closed end fund but the art of buying deeply discounted closed end funds is one of those practice that has been around forever and hardly anyone does it because it is kind of boring and not really liquid enough a market for the bigger funds to be involved. No one gets on TV for buying a closed end mutual fund and waiting around a yea or two for the style or sector to come back onto favor and eliminate the discount.

I did some articles on closed end funds for income investors this week on real Money and I got drawn into the subject. I have to refine my numbers but looking over the last couple of decades buying selected closed end funds at a discount has worked fairly well. Buying closed end funds that trade at a discount and have an activist investors file a 13D have been consistent money makers. Buying closed end funds at a discount to NAV reminds me very much of buying small banks. You will do well just buying them but if you limit your universe to just those with an activist involved you get something of a turbocharge effect.

I have just started examining closed end fund arbitrage as a consistent approach but the latest academic work on the subject wa conducted by Dilip Patro, Louis R. Piccotti and Yangru Wu. The concluded” We find significant evidence of mean reversion in closed-end fund premiums. Previous studies substantially understate the magnitudes of arbitrage profits in the closed-end fund market. Capitalizing on the property of mean reversion, we devise a parametric model to estimate expected fund returns by incorporating the information content of a fund’s premium innovation history. Our strategy of buying the quintile of funds with the highest expected returns and selling the quintile of funds with the lowest expected returns yields an annualized arbitrage return of 18.2 percent and a Sharpe ratio of 1.918, which are substantially higher than the corresponding figures produced using the extant methods. The results are robust to a wide range of tests. They greatly deepen the closed-end fund discount puzzle and pose a challenge to the market efficiency in these products.”

Add an activist to push for the reversion and we have a winning approach that should perform well. I need to crunch some more numbers but I think this overlooked approach is viable and incredibly useful in a low rate world. We already added one such situation to the income portfolio and do not be surprised if you see more in the weeks and months ahead.

Now its off for an evening of wine, a sad dog and a good book.

Cheers,

Tim

If anyones looking for me I’ll just be hanging around waiting for https://www.youtube.com/watch?v=Nkh3DuWIdSw to get back…