Tuesday, February 12, 2008

Mixed signals

On the face of it. the world would appear to remain a distinctly unpleasant place. AIG announced yesterday that it was the latest "winner" of the dodgy accounting sweepstakes. The market reaction was swift and predictable, as AIG dropped sharply on volume of 100 million shares. One might posit that there is some signal there.
Meanwhile, the ECB seem to be going out of their way to quash market hopes of near term rate cuts; while it makes Macro Man feel a touch better about his option overlay from last week, it should not, on the face of it, be a positive for risk assets. And indeed it has not, for many. Credit continues to get smoked, EUR/ISK has traded up to 100 today, and even the TRY has weakened so far this week. Everywhere you look, it seems like someone is putting out a fire. So why the heck did the SPX closer higher yesterday?

Given that credit in its many guises has paved the road to perdition on which equities appear to be travelling, it is instructive to observe the relationship between the two. The chart below shows the SPX with the Itraxx Euro Crossover Index, a useful proxy for all things credit. (Note to professional readers: this is the "57" index, rather than the current "58", which is used to provide a longer history.) Unsurprisingly, the correlation has been pretty high for the last year, particularly since the credit crisis kicked off properly in July-August.
What's curious to note is that while crossover spreads have made a new high (i.e., a new low as pictured on the chart above, as the scale on the crossover chart has been reversed), the SPX has failed to do so. Might this, along with the resilience of equities in the face of yesterday's AIG news, represent some sort of "positive divergence" from equities, and thus foreshadow future gains?

Peut-etre. But it's unwise to read to much into a breakdown in the correlation between equities and credit. For fun, Macro Man ran a 1 month rolling correlation study betwen the SPX and crossover series depicted on the chart above. Unsurprisingly, since the crisis kicked off the relationship has been very strongly negative, on balance. However, as you can see below, the correlation has fallen (that is, trended closer to zero) between the two series over the last week or so. Again, might this not suggest that equities have gotten "credit crisis fatigue" and become immune to marginal bad news?
Perhaps. But look at the chart again. The last episode of breakdown between the two markets took the correlation almost to zero. That was at the end of last year- indeed, the spike high on that chart ocurred on Janaury 1. You probably don't need Macro Man to tell you what happened to equities in January.

Ultimately, this seems to confirm Macro Man's belief that the signals one receives from market pricing in this environment are unusually unhelpful in determining the state of play. Reminiscences of a Stock Market Operator is a wonderful book and almost always touted as essential reading for traders. Predicated as it it is, however, on discerning signals from market price action, the book and its lessons are probably best locked away in a cupboard somewhere until conditions normalize- whenever that may be.


Anonymous said...

Is it meaningful to graph spreads with prices?

Also, instead of using a particular XO index you could use Bloomie's generic - ITRXEXE Curncy.

I do love the blog, by the way.


Macro Man said...

LFY, over long periods of time it probably isn't appropriate to compare price with spread...given that stock prices trend and spreads mean revert. Of course, if one de-trended stock prices, it should be OK.

On shorter horizons, one could argue that most equity price action is mean-reverting noise, and that it is OK to compare the two directly.

Over long horizons, the 'continuous' Xover index is the best thing to look at...but the carry in the roll is quite large (30 bps or so), and as such can give misleading signals. That's why I used the same index for the entire study on today's post...no distorting rolls.

And thank you for the copmpliment.

CDN Trader said...

MM, you answered your own question in previous comment: "On shorter horizons, one could argue that most equity price action is mean-reverting noise."

Jin said...

Regarding SPY, a 25 Fed rate cut? I think it is expected now.

Anonymous said...

mean-reverting noise = rumours?

Anonymous said...

Hi, MM,

your charts seem to suggest that past breakdown episodes between the two markets have been relatively short-lived and have been rapidly followed by some sort of normalization (i.e. a move back toward a fairly high negative correlation between equities and credit markets…), which usually takes a few days to a couple of weeks to be completed. What if bonds move down instead of equities, perhaps after some American Oracle proffered his prophecy from his headquarters in the prairies…

Read you later, AT