Tuesday, July 08, 2008
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.