Wednesday, 15 October 2014

A Market Post-mortem and View of the Afterlife.

This is the least 'fundamentals driven' correction we have seen for a while. Are people really expecting a double dip in the US? If not then the talk of 'concerns over growth' are hard to swallow. If we look at real yields they haven't fallen much until recently, unlike prior episodes of growth concerns where there was a more realistic probability of sharp slowdown.

So where did it all start? Perhaps oil is the culprit. Oil & gas are the largest sector in High Yield, (~13%) so the sell off below marginal production costs really put pressure on HY and led to the gap higher in HY spreads. Equities then followed HY. If you are someone who only looks at numbers it may well appear as a growth scare driven sell off as energy and materials are cyclical sectors and t'was they that took the biggest hit. But the other side of the equation is that whilst everyone panics over the energy sector, the rest of the economy benefits as lower oil prices lead to higher real incomes. Manufacturers must be rubbing their hands in glee whilst farmers, if they were to ever express any sort of happiness, would be dancing for joy (let's not forget that farming these days is pretty much a way of turning oil into food via fertilisers, farm machinery and transport). Perhaps the bond market saw this side and didn't really price in much of a slowdown until stocks started tanking.

Another factor is that when global yields moved higher in September, the pension funds that do automatic rebalancing programs may have sold stocks to buy bonds and the real money guys may have ended up selling to short term specs. This rebalancing could have been the reason that yields have been leading price action in stocks by about a month for the past 12 months. As yields have obviously retraced, so maybe that rebalance has been unwound.

We must also note that 30yr US treasury yields are now BELOW when Bernanke uttered the word "taper" and 10yr treasury yields are now less than 10bps above the dividend yield of the S&P. The value proposition for stocks over bonds has been the highest since early 2013. There is no recession risk in the US (stop laughing in the cheap seats) and even though Europe will have a roughly flat / marginally negative real GDP print it’s all priced in now. Europe has barely grown in the last few quarters, so it's not as though there are a lot of excesses that need correcting.

Oil - I strongly believe that oil prices won't stay here for that long. There is some infighting within OPEC regarding ISIS perhaps and oil prices have become a tool both there and in the anti-Russia game. The fact that spec longs in oil futures were also at all time highs going into this surely had a large impact too. With the chatter that $80 is the marginal cost of production for a lot of the shale producers supply should also be slowing soon, although it may take a few months for it to be felt. But my underlying feeling is that a 15% fall in two weeks is in no way substantiated by a change in the fundamental supply and demand of the huge and complex oil market. It was (and is) positional speculative and hedge forced position adjustments and as such is just as likely to move back higher again. Fill your tanks.

Europe - Disaster contagion was in full swing as correlation trades swept through the books and peripheral markets saw spreads to core scream higher again. Once again this can be explained by liquidation of stretched positions. Core/periphery spreads have been a talking point for the past couple of months so were due a creation anyway but coming in the midst of an equity rout the mood appeared to fast morph into one of Euro-panic with dealers reaching for their 2011 Euro-panic gameplay handbooks. Greece stocks down 10% at one point in the day was worse than at any point during their own crisis. But this is not 2011 again and despite Germany sticking to her selfish ways, I doubt the bond vigilantes are going to have much success further than taking the excess out of the recent compressions. Europe may be suffering a growth and deflation problem (actually bond positive) but the chances of default for the likes of Spain and Italy have not dramatically increased over the last week and they are still ultimately enveloped by OMT. This is not 2011 though the bond vigilantes may try to make it look like it.

So, despite all the recent shenanigans, you can probably guess that I'm still bullish risk. The macro backdrop has not changed, but what has changed is positioning. People may just have been over exposed and the price action today is suggestive of that with all the popular trades getting killed - short bonds, long dollar, long stocks, european periphery spreads etc and it was clear that their was real panic in the treasury market today with people capitulating with the net short position that specs have been running for the past 9 months getting unwound.

Where does this lead us? The master plan, after the ‘Bear Signals’ post at the end of September, had been to wait for a typical Sept/Oct sell off/panic to play through psychologically with the probable buy date to be somewhere around the end of October. However after today’s retracement, things look as though they are lining up for a low in risk assets perhaps as soon as next week or perhaps later in the week due to option expiration. I surmise that plenty of short dated options were bought expiring in October when this move began adding to those already bought to hedge against the risk of market volatility due to the end of QE. I would also surmise that most long-term real money will hold onto their long exposure (Larry Fink also saying they have seen no large institutional selling) and just roll the protection out. So the expiry of the October options on Friday may allow volatility to fall as dealers gamma exposure will probably drop measurably. This fall in volatility could itself become a bullish event as it leads further buyers in. Let’s not also forget the point made earlier where the relationship between yields and stocks (whereby yields have been leading by about 1 month) also suggest a low this week.

Finally, there's the time component. It seems that a 'proper' correction needs a minimum amount of time to sufficiently change attitudes, and historically, it's been roughly 4 weeks. This is the 4th week.

And finally finally, I am wondering how much of yesterday's carnage, especially in the less liquid products, can be attributed to new banking regulation. There has long been concern that the regulatory removal of bank proprietary trading positions also removes a buffer of liquidity should things start to collapse. Perhaps that was our first sighting of such an effect.


Anonymous said...

C Says
In general agreement with that take on our current situation which is why I opted to reset after a 10% phase on the Ftse. Reset means I now get to take bite of any consolidation and bottom picking. Where we differ is I'm not bullish risk if that implies we now go back to making new highs. I think the market leverage position required to do that peaked this Spring and we are in unwind mode going forward. However, there's unwind - plummet and unwind see saw mean reversion and I'm in the latter camp. If this market give me a bit going back I will pick a point to reset short risk again. The only thing that would stop me would be economic data get's so bad the central banks start making further QE noises. With rates this low I don't see that happening ,appears to me the markets fear has already done the job for them.

Corey said...

Not too many farmers I know cheering as they receive lower prices for their crops, diesel is not so much a product of fracking so it hasn't gone down like gas + fertilizer prices are sticky. Also think I agree with C on this one except I think eventually either the fed or ECB will get on board, but not till we've had a larger correction.

Polemic said...

Seriously Corey ? Diesel hasn't dropped with Oil falling 30% ?? - I understand that fertilisers are mostly gas driven these days but diesel not falling with the fall in oil?

Corey said...

I suppose I exaggerated a bit. Gas is down 13.5% and diesel about 8%. However that doesnt give you much relief when corn is down +30% and wheat not far behind. To your point thou the last report I saw when oil prices were rising was that it was good for profits since energy is the larger sector - I assume the inverse is true (although this may be dangerous). Either way I wouldnt want to be in Argentina's shoes right now they've got to be hanging on by the skin of their teeth.