Wednesday, July 30, 2008
Oh dear. So Merrill Lynch (who really ought to merge with Villeroy and Boch) announces another "kitchen sink" write-off....and the financials (and, by extension, the broader market) stage a furious rally. This left Macro Man considering the following conundrum: how can both Merrill and other banks rally?
To wit, if this really were the final write off from Merrill, and at levels much more conservative than those on other banks' balance sheets, surely other banks should be getting caned on the expectation of the coming "reality check" losses? But if other banks are OK, and this really is a Merrill specific issue....surely Merrill should get whacked on the basis that there are yet further markdowns in the pipeline?
The resolution to the conundrum can be found in one short phrase: short-covering. The price action in Merrill was hideous, as the stock rallied nearly 8% on truly jaw-dropping volume (293 million shares.) What's particularly nasty is that a large chunk of that volume was near the high print of the day, and involved lifting offers, as the chart below illustrates.
Merrill actually lagged the BKX, which tacked on 8.7% in Tuesday's trade. This, combined with the oil price getting drilled (boom, boom), led to another day of unfortunate price action in the trade known as "equity market crack": long energy and short financials. This trade, as proxied by the XLE/XLF ratio, plunged 8.6% yesterday. Ouch!
Unfortunately, it seems as if many market punters have been unable to "just say no" to equity market crack. As the chart below indicates, most "market neutral" hedge fund performance can be explained by the equity crack ratio. Why spend a percent or so in transactions costs and ETF fees when you could pay a friendly hedge fund manager 2 and 20 to do the same trade for you?
The chart suggests that market neutral guys doubled down recently, given the sharp rise in the HFR index alongside a relatively modest rebound in the crack ratio. One can only presume that yesterday was not a particularly enjoyable day for these chaps....'twill be interesting to see the HFR index when it updates for yesterday. Suffice to say that many of these funds probably wish that they'd listened to Nancy Reagan.
Let's not kid ourselves, however; this relative rally in financials is all about pain. While it may be tempting to pick a bottom on the basis of "valuation", surely Merrill's ongoing travails suggest that notions such as "book value" for financial companies is worse than useless? Macro Man is generally a believer in looking at what people do and not what they say. And when he sees KKR looking to peddle stock in itself to the public, that tells him everything he needs to know about equity valuation.
Finally, yesterday's comparison of short NZD positions to Rocky Balboa proved timely. While the kiwi traded horribly for much of the day, when the USD caught a huge bid in the London afternoon, NZD/USD inexplicably turned around and ground 2/3 of a percent higher in a straight line, breaking back above the vital 0.7380 level in New York. If you sold the break of support, that's probably where you left your stop.
Subsequently, the NZD has been shot down again courtesy of some dovish commentary from RBNZ governor Bollard. It's a reminder to "just say no" to leaving tight stop losses in the kiwi; more often than not, you're going to get filled by Clubber Lang or Apollo Creed.