Wednesday, July 30, 2008

Just say no

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.


Anonymous said...

Maybe the financial rally is related to that SEC limits the naked short on a list of financial companies?

Anonymous said...

MM- You got the ticker for the HFR index there? Would be good to see the price today...

calvino said...

Is some one determined to push the gbp/aud to 2.1 no matter what it takes? The gbp is overvalued against all currencies, imho, however the carry is my way with the aud.
Who and where is doing this?

Anonymous said...

We looked down the river and we seed the British come
And there must have been a hundred of 'em beatin' on the drum
They stepped so high and they made their bugles ring
We stood behind our cotton bales and didn't say a thing

Anonymous said...

I believe that you can get the HFR index on the plain-vanilla (don't need the professional service).

Macro Man said...

Anon, I'll post the ticker in this comment space tomorrow.

Calvino, it seems asif you're learning that there's truth in the old axiom: the best way to become a millionaire with a short gbp position is to start off as a billionaire with a short gbp position! I've given up trading gbp until merv caves in.

Macro Man said...

Anon, I'll post the ticker in this comment space tomorrow.

Calvino, it seems asif you're learning that there's truth in the old axiom: the best way to become a millionaire with a short gbp position is to start off as a billionaire with a short gbp position! I've given up trading gbp until merv caves in.

Anonymous said...

Short GBP (and NZD) are consensus positions --- which is to not to say they're wrong, but you're obviously vulnerable to squeezes. I'd also note that GBP TWI depreciated something like 12% over the last year (granted much of that vs. EUR) so one might question how much further there is to go.

FlashRabbit said...

I see the market has been hunting underneath the kitchen sink for that crack pipe again...

Corey said...

i'm noticing some slight outperformance in the yen recently...i.e. it should be doing worse considering what everything else has been doing. of course, that doesn't mean it's going to strengthen, but my bet says it will, and when it comes, it will come fast. also, short-term i'm no longer bearish on gold with today's push lower. last, i have a suggestion: for all you out there that can't naked short your favorite financial turd, just buy some yen in an ironic protest of the robust US banking system.

Anonymous said...

The question is: Why did KKR wait so long?


Anonymous said...

re: Merrill
Shouldn't short covering be indicated by rising bids as opposed to rising offers.

I'm not sure I understand the technicalities of that action too much and how you can tell whether it was buying interest or short-covering on behalf of shorts.

Anonymous said...


After consideration, I'm left with the conclusion that US equities are sunject to "systemic regulatory risk" (have I coined a term?).

Unlike the garden variety of "regulatory risk", i.e. buying oil companies in Venezuala, or Russia, where they might get nationalized, or found guilty of "tax evasion",or "enviromental" failings, in the US, one needs to worry about the Fed, the Treasury, the PPT, and God knows WHO all, mucking about in the markets at the drop of a hat....


old trader

Macro Man said...

The code for the market neutral HFR index on Bloomie is, for those interested, HFRXEMN Index GO. Surprisingly, the Tuesday update doesn't look so bad.

Anon, the chart in the post shows a lot of volume on red bars...which means that offers are paid, rather than bids hit. It is my presumption that a lot of this is short covering.

OT, that regulatory risk in the US has, to some extent, been in place since Enron, via Sarb-Ox, etc. Sadly, the current incarnation is hardly alone in the world, viz the FSA in the UK.

And I seem to remember the Europeans getting into a huff when Citi jammed a few billion euros' worth of bunds a few years ago,....

Anonymous said...

The Financial Accounting Standards Board voted to delay until January 2010 the introduction of rules that will force banks to consolidate more off-balance-sheet vehicles directly in their accounts.

Robert Herz, FASB chairman, said that the move was made reluctantly after a staff recommendation for a delay because there might not be enough time for all companies to adjust to the up-heaval.
“It does pain me to allow something that has been abused by certain folks, to let that go on for another year,” he said.

Long live the Banana Republic.

Anonymous said...

"the best way to become a millionaire with a short gbp position is to start off as a billionaire with a short gbp position!"

GBP went from 2.4460 in November of 1980 to 1.0520 in February of 1985. Ahhh, those were the days. :)

As I recall, Soros didn't do to bad shorting GBP, also (from 2.0040 on 19920909 to 1.7289 six trading days later - and bottoming at 1.4169 on February 11th of the following year).

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