Tuesday, November 20, 2007

Fear and greed

There's a well-worn market cliche that economic agents are driven by fear and greed, and in particularly difficult conditions they seem to straddle the divide between the two. Indeed, the overlap between fear and greed is one of the primary drivers of market volatility, wherein investors find themselves navigating an emotional minefield and, more often than not, doing the wrong thing.

Macro Man now finds himself in the uncomfortable position of having one foot in each camp. As he looks around, he sees several apparent mispricings which might generate some tasty alpha. At the same time, he has to acknowledge that the fundamental picture as he sees it has deteriorated; disposable income and aggregate net wealth are much more important in determining his worldview than house prices, for example, and the outlook for neither is particularly pleasant at the moment.

Moreover, financial market prices are also determined by the collective result of the fear/greed equation, and in times of severe distress notions of "value" and "ought to" go out the window. The following is a brief, non-exhaustive sampling of some of the issues that Macro Man is grappling with at the moment:

1) VIX suggesting equity sell-off is overdone? Macro Man was quite surprised to see that his favoured indicator of risk aversion barely moved yesterday, despite the sharp sell-off in the S&P 500. The reason is that despite the new recent low in stock prices, the VIX is well off its recent highs, and indeed barely rose yesterday (see below.) Such a divergence, which may suggest that the street has been layering option hedges even as Macro Man's have rolled off, would ordinarily suggest that a near-term bottom is in sight. A similiar phenomenon can be seen in EUR/USD, which, unlike in August, has plowed higher despite weaker stock prices/higher VIX. Indeed, even USD/CHF has finally made a new all time low today. All this would normally make Macro Man relatively comfortable with his new long equity market posture (following the recent option expiry)....and yet...and yet:

2) The credit market is still buggered, and there's still no bid for assets of questionable quality. ABX continues to plummet, including the "high quality" tranches, to a degree that suggests that bidders have completely stepped away from the market. Meanwhile, Northern Rock, which could be considered an equity version of structured credit, is rapidly approaching the price target that Macro Man set two months ago.

The problem with the Rock, summarized here, is that it's unclear who has the authority to dispose of it, and in any case such potential buyers as actually exist simply wish to cherry-pick the less odious aspects of the franchise. So in a very real sense, Northern Rock is a barometer for credit conditions generally: it is a deeply flawed asset, the ownership structure of which is opaque, that in certain aspects appears to have some intrinsic value but in others very little at all. Perhaps we need to see this sucker go bust in one fashion or an other in order to mark a near-term low in sentiment? In that case, there's more bad news ahead- another lender, Paragon, has admitted significant distress just this morning.
3) US consumers finally beginning to feel the pinch? One of Macro Man's firmly held views is that consumer spending is driven by disposable income (primarily) and by aggregate net wealth. Sure, the housing market has a deleterious impact upon this equation, but its impact is surprisingly small relative to the volume of headlines.
However, Macro Man has to acknowledge that the outlook for the erstwhile supportive factors of income and aggregate wealth is looking a tad ropy. Macro Man has already enumerated his concern over energy prices in the recent past, and sure enough retail gas prices have now climbed to $3.13, with Macro Man's model forecasting a move to nearly $3.50. Such a move, if and when it occurs, should apply a very real hit to disposable income, and by extension real discretionary spending.
At the same time, household wealth has weathered the housing storm reasonably well to date. True, the distribution of stock market wealth is not as evenly distributed as housing wealth, but the modellers with whom Macro Man has discussed this issue suggest that the consumption function from equity wealth is broadly similar to that of housing. The situation, as it recently stood, was that y/y housing wealth was at its most negative since the data begins, whereas aggregate wealth was relatively resilient due to stock market strength.
Well, recent stock price declines, if sustained, would surely push gains in aggregate net worth closer to zero. And that also has implications for consumption. While inventories currently look fairly healthy, a disappointing Christmas retail season could change that pretty quickly. And recent earnings disappointments from retail are also not encouraging.
Now, Macro Man still does not expect a recession, and believes that "muddle through" is probably still the best base case for the next few quarters. Gains from trade, for example, are providing a significant buffer to the economy. That having been said, risks from the above issues are clearly rising.
While the Fed seeems happy to acknowledge these risks, for the time being they are equally (and, in Macro Man's view, justifiably) concerned with inflation. Tonight's minutes will be especially significant, containing as they do the first iteration of the new forecast/commentary regime. Hopefully, they will provide some hint about what the Fed would need to see to change its stance in either direction. However, such an outcome might be wishful thinking.
For the time being, this Fed reminds Macro Man of a parent in the process of "training" a spoiled child. As any parent knows, giving in once to a child's request (for treats, to stay up, to watch program X, to play game Y) establishes a precedent; giving in twice establishes a new routine. The Fed gave in on satisfying the market's demand for liquidity in October, and they are trying their damndest to avoid a repeat for next month's meeting.
What it means is that the Fed might need to see the market price out some easing of policy before it feels comfortable delivering said easing. Put another way, it may wish to see breakevens decline and the curve flatten before trimming rates again. If this is the case, then equities could be in for a bit of a rough ride. And yet the VIX is suggesting a bounce may be in the offing.
A more obvious area to look at is the Treasury curve, where 2 year yields fell as low as 3.13% yesterday. To buy 2 years at that level, you pretty much need a recession to make money. As that is not the Macro Man base case, it is a useful place to look for a correction. Macro Man therefore sells 200 TUZ7 at 104-24, risking 105-04. This provides a partial duration hedge of his long TIPS position. True, there's an embedded flattener as well, but for the near term that appears to be what the Fed would like to see.
Seperately, central bank buying has propelled EUR/USD to fresh all time high. The degree to which the market has shrugged off equities is impressive. And yet, in the back of his mind, Macro Man cannot shake a certain amount of fear; gold, for example, remains well, well off its highs. Macro Man has had an excellent run with the short dollar trade, but has to acknowledge that valuation is becoming a bit eye-watering, particularly now that Europe appears to be actively seeking a weaker EUR versus RMB. He therefore banks some profit, selling €20 million versus USD at 1.4785 spot basis.


Anonymous said...

do you have an idea of the reability of vix bullish divergence?

Macro Man said...

Not scientifically, which is why I point it out but don't take it as gospel.

prophets said...

I am almost entirely driven by fundamental bottoms up, single stock analysis. But I have to say, that the Nov. 8th intra-day price action in Citigroup and single day surge in the VIX that very day made me think we were starting an intermediate term bottoming process. I thought it was quite curious.

The sooner we reach bottom in equities, the quicker foreign investors will be to snap up cheap US companies. It could help buttress the ailing dollar.

Bill Luby said...

Good stuff, Macro Man, from a long time reader.

For the record my research indicates that a high positive correlation between the SPX and VIX is more likely to precede a market downturn than a high negative correlation.



CV said...

Another good post MM ...

And when will the Dollar whipping ever end? The EUR/USD is at 1.48 and rising and the USD is even close to parity with the Swissie :).

Well, we will see just how far the fundamentals can get strected but the longer this muddles on the more I worry that the Eurozone will have to say bye-bye to one or two members. Especially, if CGC de-pegging leads to a violent sell-off of USD denominated assets.

Portugal clocked in 0.0% GDP q-o-q in Q3 and Italy for all intent and purposes is headed straight for a recession. If German corporate capex grinds to a hold as many analysts are predicting the whole edifice will come down very quickly I think (i.e. the ECB will need to lower rates).


Macro Man said...

Bill, have you done any work on the postitive divergence observed yesterday, e.g. SPX makes a new low (say over a 1 month horizon) but VIX does not make a new high? If so, I'd be curious to know if there's anythign there; if not, maybe I'll have a look when I get some time. Regardless, the 'divergence' signal isn't working today...

Claus, I'd agree that EUR/USD (or, more to the point, EUR/RMB) is the wrong price; but the first rule of currencies is that the wrong price get get wronger and stay longer than you'd expect. The major demand drivers, CBs, are still in play; they've been seen buying on a 1.48 handle today. If the dollar countertrend rally is going to happen, I'd suggest new year as a likely timeframe, when CBs recede from prominence and threre's another 1-2 months of crappy data for the ECB to digest.

Anonymous said...

macroman -- any sense of which CBs have been selling $? tis interesting news, but it might just reflect the fact that reserve growth looks to have picked up once again. the oil guys are flush and the RBI has been intervening quite significantly over the past couple of months (no oil there) and it consequently has to sell a lot of $ just to meet its targets.


t said...

30% off freddie mac: fear wins?

Bill Luby said...


Regarding the divergence between SPX lows without corresponding VIX highs (or vice-versa), I have looked at the charts in a casual manner, but haven't taken the subject on as a formal research project. If and when I take this on, I'll do my best to remember to fill you in on my conclusions.



Charles Butler said...

I'd suggest that the relationship of the VIX (or better its inverse) to the S&P behaves similarly to a 'momentum' indicator, like the RSI - its reflexes becoming weaker under repeated stimulus. Both are good signals if your take on the situation is fundamentally correct. If that's not the case, they're just inevitable results of their own makeup and have no value whatsoever.

Macro Man said...

Brad, there have been several, and for fairly obvious reasons: oil revenues, rserve accrual from certain Asian CBs, and of course the need to get portfolios to benchmark at year end.

The very fact that these guys continue to buy EUR at such eye-watering levels is instructive. Even as the dollar rallies against a lot of other stuff, it goes down against the euro (as well as erstwhile funders yen and CHF.)

It does seem, however, that they are less active in sterling these days, perhaps because of the obvious warts in the UK economy.

Jin said...

In US, the consumer spending will continue being weak for a while. According to my source, neary all states see a flat sale tax growth(taken other factors into consideration, such as tax rate...) in the next 6-12 months.