Black Tuesday?

S&P futures are limit down in overnight trade (-70 points), the SENSEX has been beaten senseless, and the IBOV (Bovespa) is definitely bovvered at the moment. Two year US swap yields are 25 bps lower and European equities are down 3-4% in pre-market trade, having shed 5-7% yesterday. Meanwhile rumours are flying that some recently-announced capital injections into US banks may be scuppered as the SWF investors get cold feet. Today is shaping up as a day that could live in infamy, one of those days that in subsequent years is prefixed with the word "black."

Will it happen? Will US and, by extension, global stock markets pay a visit to the extreme left side of the return distribution today? It's certainly possible, but unfortunately such events are products of psychology more than sober fundamental analysis, and as such are vrey difficult to predict with accuracy. What is clear is that market liquidity is extremely poor, and dealer appetite to warehouse risk in any market is zero.

There are some stories that the Fed may cut rates today, but such rumours are more the product of hope than expectation; similar whispers have been heard on and off for the past several weeks. On the one hand there would appear to be little macroeconomic utility in cutting rates today with a regularly-scheduled FOMC meeting in a week's time; on the other, if markets show signs of disorderly collapse, an emergency cut could perhaps stop the bleeding temporarily and be followed up with a regularly-scheduled 50 bps next week. Macro Man would frankly be surprised if the Fed did cut rates today, but would not be particularly shocked if the SPX finished down 100...or closed higher on the day. It's that kind of market.

While succeeding today will probably depend on one's trading nous, there are a number of medium-long term trends that warrant review. Macro Man specifically refers to his view that despite the rise in volatility, the expected return in classic "risky" trades would remain positive. This view is receiving a significant challenge, and at this juncture Macro Man wishes to consider whether we may indeed be on the cusp of a secular change in trend, an idea that he kind of rubbished a couple of weeks ago.

One notable development yesterday was in Europe. Yes, the scale of the decline in European indices verged on the historic, but that in and of itself was not that remarkable. No, what struck Macro Man was the incredibly sharp rise in implied volatility, proxied by the VDAX below. While it could of course be a false alarm, the scale and speed of the rise in volatility is reminscent of H2 2000 and H1 2001, the onset of the last bear market. And for one of the few times since the onset of the crisis last summer, VDAX has traded above the VIX...suggesting the potential for considerable downside in German markets. If so, the DAX short should continue to be a star performer.

Other equity markets are looking vulnerable to a trend change as well. Consider the Bovespa, the darling market of the darling country of the darling asset class. It's come so far, so fast that it's best viewed on a logarithmic scale, in which equal percentage moves are reflected by equal physical distances on the chart. While it's yet to breach its bull-market uptrend, the Bovespa is sitting perilously close to doing so.

The FTSE in the UK has been flirting with such a trend break for the past several months, but looks to have conclusively shattered support with this month's downdraft. While much of the investment into the UK has been of the fixed income variety, courtesy of FX reserve managers, the implications of lower stock prices for the City, the economy, and sterling should not be terribly pleasant. Macro Man is happy to retain the sterling basket short.

A broader perspective on sterling is sketched out below, with a long-term chart showing the nonpareil intra-European carry trade, GBP/CHF. Much like the FTSE, this month has seen GBP/CHF definitively break through long-term support, in this case an uptrend line drawn off the 1995 low. This chart reflects not only the bearish potential for sterling, but perhaps also a bullish case to be made for the Swissie. Insofar as the CHF has been caned as a result of carry trades/excess global liquidity, the withdrawl of the latter and closing of the former bolster the Swissie's prospects on a cross basis, much like that of the yen (viz. the EUR/JPY chart posted yesterday.)

And of course, intra-market thematic trends have also shown signs of trend reversal. One of Macro Man's favourite positions is the long large cap/short small cap spread trade, which has been pretty successful so far. Trends in this relationship, proxied by the OEX/RUT spread below, tend to endure for 5-10 years. The sharp downtrend broke a year and a half ago, but it is only recently that the spread has started to move impulsively in large caps' favour. As the scale of the chart indicates, there is ample potential for further gains of 20%+, an outcome that would fit quite well with the consensus view of US consumers finally rebuilding their savings.

If one long term trend looks set to break, it can be written off as noise. If it's two, then perhaps it can be called a coincidence. But when a large number of long term trends are breaking, it behooves one to take notice. Macro Man is not prepared to go all in on the short side, just as he is not yet prepared to scrap his "muddle through" economic base case. But he has to respect what he sees and at least countenance the possibility that we are in fact in the early stages of a bear market in equities, credit, and other risk assets.

In the short term, a consequence of volatility and uncertainty is that the world may be turned upside down. Consider that as of last night's close, the best performing global major stock market in dollar terms year-to-date was....wait for it....the Nikkei. Perhaps Cassandra will have her day in the sun.

And what of the very long term? Well, if this truly is a bear market, we really haven't even scratched the surface of how low stock prices could go. The chart below shows the SPX since 1928, using quarterly data presented in logarithmic form. While the bear market following the tech bust stands out as being relatively acute, the current downdraft is scarcely a blip on the chart. If (and it's still a big if, though perhaps more likely than it seemed a few weeks ago) we have entered a new secular bear, there will be plenty of money to be made on the downside.

In the meantime, Macro Man has to respect the fact that markets are trading on the basis of fear and psychology rather than on the basis of what are commonly referred to as "fundamentals." As such, a little portfolio surgery is probably in order. The silver long has gone from a tidy profit to close to flat; Macro Man cuts that at 15.63 to avoid moving into the red. Similarly, short fixed income, no matter how rich it may seem, would be appear to be foolhardy in the event of a "black" event. Macro Man therefore cuts his US 10 year payer position in half, receiving at 4.12% in $10k/bp. This leaves him with a longer duration position, which is not a bad place to be when markets appear perched on the brink of a precipice.

Note that the P/L has been amended so that the SPY price reflects levels currently priced into futures markets rather than Friday's closing levels.