Tuesday, July 08, 2008

Go ugly early

European markets have pursued a strategy of "go ugly early" this morning, with major indices gapping down and most trading more than 2% off of yesterday's closing level. The reason, of course, was yesterday's frankly bizarre price action in the SPX, which went up and down like the elevator in a high-rise office building.
Consider, if you will, yesterday's roller-coaster ride and some of the rationales ascribed to the price action:

A: Oil's off three bucks and Barron's put the bear on the cover. The bull is back, baby!

B: Oh no! We've suddenly realized that Freddie Mac and Fannie Mae have a lousy business model and are, well, buggered!

C: Hurrah! The government will bail out Fannie and Freddie!

D: Err....with what money?

Feel free to fill in your own captions to explain yesterday's craziness.

Perhaps the best word to describe yesterday's equity price action is "schizophrenic." What was particularly odd about yesterday was that despite the intraday volatility, a new closing low, and the first trading day after a long weekend, VIX barely budged. Now, one could take this as a sign of complacency, a sign that longs are still not prepared to pay up for insurance. On the other hand, one could interpret it as a sign that the market is already short and/or hedged, and thus liable for a squeeze.

So which is it? Macro Man ran a little study to try and find out. He regressed the daily return of three HFR hedge fund indices- equity funds, "market directional" funds, and macro funds- with the daily return of the SPX, using 20 day rolling correlations. A positive correlation implies that the strategy in question is long, whereas a negative correlation implies short positioning. The results were pretty interesting.
As the chart above indicates, macro funds are really quite short, exhibiting the highest negative correlation to equities since the financial crisis began. (As an aside, this ability to profit from pain is one of the primary rationales for investing in macro.) Equity funds, while less long than a few months ago, still retain a healthy net long beta, according to the HFR data. The same holds for so-called directional funds, which appear to travel in only one direction- long. What's particularly interesting is that the correlation of the equity funds to the SPX has risen over the last couple of weeks, suggesting that there's been at least some appetite to buy the dip.


So what to make of this? Macro Man frankly isn't sure. He retains a modest equity short in his book, but he has to concede that the attraction of shorts is a bit less compelling than it was 160 SPX points ago- especially as it's becoming evident that major central banks, even the ECB, don't really intend a "hike you back to the Stone Age" policy. However, an intermediate low may not be reached until the recent dip-buyers are forced to puke.

On a longer term basis, however, the outlook continues to look grim. Sometimes the simplest analysis can be the best. Two and a half weeks ago, Macro Man noted a bearish long-term head-and-shoulders on the Eurostoxx weeklies. Since then, the index is down 6% and ultimately targets a lot lower.

Equity weakness also finally seems to have attracted the notice of fixed income markets. While the US 10year future has a host of previous highs around 116 to surmount before really taking off, the recent break of the 55 day moving average could get the black box guys stuck in; one wonders if they are at least partially responsible for the surge in short end contracts, for example.
With Bernanke due to testify next week, Macro Man remains happy to sit on the sidelines in US fixed income. His forays into that market over the past couple of months have taught him that he's not seeing it particularly well, and in this environment he prefers to concentrate his attention on those markets where he has a bit of mojo.


CDN Trader said...

Bloomberg says that the stock slump isn't over until the VIX spikes. I can't help feeling that Goodhart's Law must apply in this situation. Thoughts?

Macro Man said...

CDN, to a degree, that's what motivated the correlation study. I am really surprised that VIX isn't higher. Then again, I'm also surprised that FX carry, for example, isn't lower. So the answer is that I really don't know, which I have to confess isn't a terribly comfortable feeling...

Anonymous said...

am i going mad but given how extremely oversold (i feel we are in a bubble of short financials!) the financials are, would u agree that the there is a high probability of a short squeeze during the upcoming financial earnings?

.....i mean even if results come SLIGHTLY worse than expected, i can see financials rallying quite hard over the next few weeks which will be boosted from the pricing out of rate hikes from Fed

not only that but also a continuation of lower oil prices will be positive.... Asia em fx should roar on the back of this......thoughts?

Anonymous said...

Well, that was the script last time around, Anon, and had me tempted to close a position thinking along the same lines as you.
One thing that may be of note is the up tick in volume of the levered financial etf (UYG). It's basically 2/3/4x that of Mar/Apr/May.
I wonder if, in spite of the steady torture we’ve seen, there isn’t quite a few more folks than one would think positioned for just your scenario.
Not sure if it’s complacent or smart??

Anonymous said...

yes i wanted to finish my question with a "maybe what I am saying is nonsense. Stick to what works, and just wait for the many who, are thinking that this selling is overdone, to stop out for trying to pick bottoms"

so true, probably complacent....will keep things light and let the price action tell me what to do...thx vm

Steve said...

I love your head & shoulders chart! So clear.

We had a very strong rally in NY today, all of the dogs transformed into princesses and rallied like banshees. Most of the really downtrodden names were up at least 10%, some much more. Real estate screamed.

So...beware a retest of that neckline, I think the market could go up 4-6% before completing the pattern.

CV said...

You got to love this world where heads and shoulders are forebearings of bear markets, where dogs turns into princesses, and subsequently rally like banshees :)

On the face of it I would say that equities still have some way to go on the downside but with oil taking a breather today it is perhaps apt to stay clear.

How do you guys see the whole dollar smile scenario. Some of the most seasoned currency analysts are muttering about a dollar rally against almost everything but the Euro. Is it time to punt on the buck?


Anonymous said...

wait until the USD rallies 1-2% and then jump in....prefer to miss the first move and then get in for the meat of the action than be early and wrong.....unfortunately so long as equities,the world, etc is trading poorly don't think the Fed will have the guts to hike and therefore the USD will not have the potential to rally....

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