After the rallies on Wednesday and Thursday, along with the revelation that the earlier meltdown was rogue trader-related, markets were perhaps justified in expecting an extension of the snapback in risk assets (though some, like the Turkish lira, had already recouped 70% of their losses.) After Friday's steady selling into the close, traders can now ask themselves "was that it"?
Certainly last Wednesday, Macro Man had targeted 1360 on the S&P 500 as a possible retracement target. Well, we got there, Macro Man cut some of his short risk, and then we turned back down. Could that really have been all there was to the rally?
Well, clearly it's possible; after all, the move to Friday's 1368 high fulfilled a number of retracement criteria. As noted above, it was an attempt to recapture the erstwhile support level, which was rejected. It was almost exactly a 38.2% retracement of the move down from the mid-December high. And it bounced neatly off of the downtrend line off of that mid-Dec high around 1500. All in all, it looks like a classic corrective pattern.
Paul Kedrosky did an interesting little study on intraday bounces last week, following on from Wednesday's sharp reversal. What struck Macro Man about the study was not the conclusion, which was pretty ambivalent, but the data itself. As far as Macro Man could make out, 8 of the 10 largest intraday spikes in the Dow occurred during what could be termed bear markets. The other two, in 1987 and 1997, occured during times of extreme financial market stress (The '87 crash and the Asian crisis, respectively.) While Wednesday's spike didn't make the top 10 list of percentage intraday moves, it was still pretty impressive. And judging by the weight of history, these types of moves occur during secular bear, rather than bull, markets.
Unfortunately for many hedge fund investors, their managers may not be positioned for such a development. The Sunday Times published a by-now well-circulated article alluding to signs of stress in the European hedge fund community. Macro Man decided to investigate, and ran a broader version of the correlation study he did a few days ago. He ran rolling correlations on the SPX and the HFR NAV indices for global macro, equity, market neutral, and market directional hedge fund strategies. (Note: he regressed price, rather that daily returns, to filter out any reporting lags. Using daily returns, the correlation signs are identical, albeit with smaller absolute values.)
The chart makes ugly viewing for equity hedge fund investors, and not just because of the garish Excel 2007 colours. (As an aside, can someone please explain why MSFT decided to radically change Excel, making it more difficult to copy forumlae and to format charts? Why change a tried and tested winner? Can somone say "New Coke"? Macro Man likes Vista but hates the new version of Office.)
All three categories of equity hedge fund are displaying a high degree of correlation with the SPX- including the so-called "market neutral" funds. Perhaps this is the real reason the market failed on Friday; funds are long and oh-so-wrong, and looking for any opportunity to trim their long positions. If that's the case, then bounces may well be short lived until we see equity funds with a short(er) exposure to market beta, in which case rallies will be the pain trade.
And given what we've seen so far in 2008, wagering on the pain trade seems like the only safe bet in town.
Certainly last Wednesday, Macro Man had targeted 1360 on the S&P 500 as a possible retracement target. Well, we got there, Macro Man cut some of his short risk, and then we turned back down. Could that really have been all there was to the rally?
Well, clearly it's possible; after all, the move to Friday's 1368 high fulfilled a number of retracement criteria. As noted above, it was an attempt to recapture the erstwhile support level, which was rejected. It was almost exactly a 38.2% retracement of the move down from the mid-December high. And it bounced neatly off of the downtrend line off of that mid-Dec high around 1500. All in all, it looks like a classic corrective pattern.
Paul Kedrosky did an interesting little study on intraday bounces last week, following on from Wednesday's sharp reversal. What struck Macro Man about the study was not the conclusion, which was pretty ambivalent, but the data itself. As far as Macro Man could make out, 8 of the 10 largest intraday spikes in the Dow occurred during what could be termed bear markets. The other two, in 1987 and 1997, occured during times of extreme financial market stress (The '87 crash and the Asian crisis, respectively.) While Wednesday's spike didn't make the top 10 list of percentage intraday moves, it was still pretty impressive. And judging by the weight of history, these types of moves occur during secular bear, rather than bull, markets.Unfortunately for many hedge fund investors, their managers may not be positioned for such a development. The Sunday Times published a by-now well-circulated article alluding to signs of stress in the European hedge fund community. Macro Man decided to investigate, and ran a broader version of the correlation study he did a few days ago. He ran rolling correlations on the SPX and the HFR NAV indices for global macro, equity, market neutral, and market directional hedge fund strategies. (Note: he regressed price, rather that daily returns, to filter out any reporting lags. Using daily returns, the correlation signs are identical, albeit with smaller absolute values.)
The chart makes ugly viewing for equity hedge fund investors, and not just because of the garish Excel 2007 colours. (As an aside, can someone please explain why MSFT decided to radically change Excel, making it more difficult to copy forumlae and to format charts? Why change a tried and tested winner? Can somone say "New Coke"? Macro Man likes Vista but hates the new version of Office.)All three categories of equity hedge fund are displaying a high degree of correlation with the SPX- including the so-called "market neutral" funds. Perhaps this is the real reason the market failed on Friday; funds are long and oh-so-wrong, and looking for any opportunity to trim their long positions. If that's the case, then bounces may well be short lived until we see equity funds with a short(er) exposure to market beta, in which case rallies will be the pain trade.
And given what we've seen so far in 2008, wagering on the pain trade seems like the only safe bet in town.
12 comments
Click here for commentsMM, regarding my comments/question on Friday, it seems that you have decided on the second alternative (small plateau from which market will fall further)?
ReplyFor all those absolute beginners out there (quorum ego…) - would you please briefly summarize the different trading styles and market approaches of each hedge fund category?
ReplyBy the way, I fear sterling is a die hard case, but last week move in GBP/USD could be the squeeze up you actually had been waiting for earlier this month…
AT
AT,
ReplyHFR's HFRX indices have brief strategy definitions at:
HFR Strategy Definitions
--Q
CDN, I am keeping open mind. At this juncture I tend to think that the next 5010% in the SPC will be lower, but the next 25% move in the SPX will be higher. It seems to me that corporates ain't misbehaved enough to have a real bone-crushing earnings recession. Even with SPX earnings of $75/share (below the most bearish estimate that I can find on BB)and a very modest multiple of 15, you get a price target of 1125. If one raises either the earnings estimate, the multiple, or both, you get a higher target level.
ReplyAT, sadly I was filled on the balance of the £ order at my originally intended level. At this juncture I have no real desire to add, especially given that the Fed is making it easy to hate the dollar again. As for the startegy explanation, I hope that Quarrel's helpful link answers your query.
Thanks a lot, Quarrel...
ReplyAT
Again on the sterling short - everybody seem to have been talking a lot on such a trade but much fewer seem to have been positioned accordingly…
ReplyIf I’m not wrong, the idea of shorting sterling originated from your firm belief that the current UK macroeconomic backdrop resembles that of the US with a six to nine months lag, and that BoE is therefore likely to be forced to cut rates in the coming months. You subsequently made your guess for a cut of at least 150 bps clear…
At the same time, GBP had unfortunately already lost ground both vs. USD and EUR, making a further GBP short kind of uncomfortable, to the point that you decided to wait for an unchanged BoE interest rate decision to squeeze up the market…
If that was the case, how about selling an out-of-money call on Cable (with a strike well above 2.00) or an out-of-the money put on EUR/GBP (with a strike possibly at 0.72 or even lower)? Wouldn’t it have been an alternative way to short sterling, allowing you more room to be wrong?
Provided that no BB was around to be seen, acting so to partially spoil your careful and well-thought plans… of course!
AT
Hello there.
ReplyThe interesting question is, imho, do helicopters have a reall impact for now.
The refinancing of mortages is at highest level from 2003, and if Ben cuts another 50 bp, it will be at all time high.
(I look at FHAVRFI$ in BB)
Correct me if i am wrong, but that means a lot of cash to CDO/CMO holders very quick, since refinancing is new mortage origination and the old one gets paid of, right?
I am not an securitization expert, so i do not know which tranches will het cash first - equity or seniour. Ofcourse overall complexitty of this market make it impossible to get a more o less precise answer.
Brad Setters writes that market for mortages have been effectively nationalized with only agencies on the buy side. For me this mean that there is a "quiet" bail-out going very quick and the result will be an expantion of goverment or semi goverment debt and lower dollar?
Any thoughts on this?
@Flipper:
ReplyI don't think that there's refinancing, only a modification of floating rates.
The mortgage isn't paid fully, only interest and eventually amortizing change.
But I too i'm not a cdo expert...
Fabio
AT writes: "Wouldn’t it have been an alternative way to short sterling, allowing you more room to be wrong?"
ReplyAnother way of shorting the sterling is to short the GBP/CHF cross as CHF is likely to appreciate in the current environment.
@flipper
ReplyIt depends on the CDO, they are not standardizes. With a standard MBS, refinancing would be effectively a prepayment (=early redemption of principal), but that's not very good from bondholder perspective either (as the stream of future coupons is smaller). Of course, it's much much better than a default.
With CDO, remember what equity tranche means - it's the first to carry any loss. In theory, if all underlying debt in the CDO defaulted at once but had recovery rate of 100%, even equity tranche would suffer no loss.
In other words, it prepayments effectively have no effect on equity tranche and reduce the risk of super senior tranche.
That said, you'd have to reach about 80% perpayments to start going into mezzanine (as the detachment point for mezz is about 15-20%), so prepayments even of 50% of mortgages will not do much.
As MMI says, if it's not refinancing (=legaly winding up the old mortgage and establishing a new legal contract for a new mortgage), it has no impact.
My idea was, that super senior transhes should be free from prepayment risk also.
ReplyThe only knowledge i have on securitization is from cfa level 2, and it was a long time ago, so i need an expert to explain:)
Now why that is not refi's? Could you explain in some more detail?
There was an arcticle on BB that since long term mortage rate have fallen now to lowerst since 2004, refi is up a lot, and there were interviews with brokers, etc.
It was on the top news list on a day we had 600 points dow reversal, but now i can not find it...
My understanding is that since Bernanke now is injecting lquidity directly into the sistem and you can get funds using CMOs/CDOs as collaterall, the impact on refinancing ability of ALT- A or better quality aplicants should be much less than expected.
And if refinancing indeed involves true new mortage origination, as it's written on many mortage brockers web sites and that is what i recall from the theory, many bond holders will get a lot of cash soon.
That will clean the balance sheets of financials to a certain degree and lower strain on bond insurers.
BTW, i recently read that typical insurer does not provide a guarantee on immidiate principal and interest recovery in case of default, only then due, so if we have a 20-30 years subprime CMO/CDO, their losses will be gradually spread over that period. If it is true hell knows that the rate of inflation we'll see during that time...
Any comments on this?
Prepayment returns the cash to you, so you need to reinvest it. If you were expecting a bond paying 7% and instead you have a chunk of cash you can invest at 3.5% or thereabouts, you have a significant problem.
ReplyCDO covenants vary, and I can see case for paying interest first on both equity and senior tranches.
One of the reason why everyone and their dog were willing to write mortgages was that they could get rid of it really quickly. So the originators didn't end up holding the risk for any extended period of time.
Of course, the problem now is that that you couldn't give away an MBS, not to mention to sell it. That said, you could probably create MBS just for the purpose of repoing it out to Fed :), not intending to sell it to anyone.
So yes, those that the banks will be happy to carry on their balance sheets will be able to refinance, but those who will not will not be able to refinance even on the low rates.
Also, you'll be refinancing on the market in dowturn, so you'll likely be able to refinance less than you could have before, which implies you need a reasonable amount of equity to refinance in the first place.
In general, I think there has been a whole lot of "value" generated, and it's disappearance will have to hurt someone. I suspect that the banks will try to pass on as much hurt as they can (and as legislators allow them) on the homeowners.
As I wrote sometime in other comment, you can make the adjustment either by deflating the values or inflating the rest of the world - and at this time it seems that Fed tries its best to do the latter.