Bears Have Rallies, Too

Bear markets are famously difficult to trade. Why is that? Perhaps it's because most investors are natural buyers and owners of risk assets, so the secular market direction leaves them out of pocket and damaged psychologically. Thus when the faintest whiff of a trend reversal, however temporary, materializes, they are naturally inclined to jump all over it, generating out-sized short-term returns. This is why Macro Man asserted yesterday that 10% daily rallies don't occur in bull markets.

Of course, when reality sets in once again and the underlying bear emerges from his hibernation, risk asset longs are left more out of pocket and more discouraged than before. Lather, rinse, repeat.

In any event, it seems that the dawning of the latest bear market rally is here. Perhaps it's driven by month-end rebalancing considerations. Perhaps it's driven by the forthcoming election of St. Barack. Or perhaps it's just driven by bear fatigue. Yesterday's late session swoon by US equities notwithstanding, it does seem like it's here. (Of course, there's also been news...but since when did that matter?)

Of the three explanations above, Macro Man favours the first and the third. The first speaks for itself and should pass within the next few trading days. The third represents a waning downside momentum as sellers of risk assets received a deteriorating marginal bang for their buck. Positive divergence (rising momentum with lower prices) has been observed in both the SPX....
...and the AUD, among a host of other currencies. With market liquidity getting worse by the day (who knew that markets would join Wal-Mart in starting the Christmas season before Halloween?), it doesn't take a whole lot to push things a long way. Currency markets are now in full-fledged "buy back your risk currency shorts" mode; USD/CAD has fallen as far as 8.5% from Tuesday's high!
So what do you do from here? Stick to your risk-asset shorts and wear the short-term pain, which might be very substantial indeed? Or go long risk for a rental and hope you can sell out to someone else before the music stops? For Macro Man, the answer is "neither." Bear market rallies are like bad oysters; if you partake, you've gotta be pretty lucky not to end up being sick. He'll pass, thanks, trim his bear market risk and concentrate on stuff with a more powerful, long-term macro theme (oh, and where he has his risk in limited-loss strategies.)

Macro Man decided to pursue yesterday's line of historical enquiry a bit further to try and get a sense of how the current market stacks up to history. The chart below shows every daily return in the Dow since 1995. Two things quickly emerge from the chart: 1) how quiet the market was from 2003-2006, and 2) the degree to which recent volatility has significantly exceeded that observed by anyone who's younger than, say, 45.
So how long do exaggerated periods of volatility last? The chart below shows daily Dow returns going all the way back to 1922, along with two standard deviation bands around zero. (Six months of rolling data were used to calculate the bands.) Here you can see how the recent upside volatility is unprecedented since the Depression. What's interesting to observe is that, '87 crash excepted, volatility (as expressed by the width of the SD cone) does seem to trend over multi-year periods. It's hard to escape the conclusion that even when things "normalize", markets will carry a significantly higher risk premium than they have over the past few years.
Finally, Macro Man thought it would be interesting to put recent activity in currency markets into perspective. The dollar's uber-rally (against everything but the yen) has certainly seemed impressive, but doesn't look particularly extraordinary in the context of the entire post-Bretton Woods era. To be sure, it has risen dramatically from the bum-clenchingly low volatility of 2006, but doesn't particularly stand out when compared to the heady days of the 1980's, for example.
For choice, Macro Man expects the dollar's strength to eventually re-emerge; it will take more than an equity bounce and a few swap lines to quench the market's thirst for dollars as the shorts of the past few years are bought back. But as with equities, it's likely to be a bumpier ride than many folk are used to.
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Sean Maher
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October 30, 2008 at 10:23 AM ×

Great SD chart of the 1929-33 experience, dangerous trade to short the Vix for too long! Bear rally indeed, and could last to year end, but incoming economic data for October should be truly grim given the 9/11 scale confidence shock of media depression hysteria, so bullish sentiment will be sorely tested.

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Anonymous
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October 30, 2008 at 10:31 AM ×

MM (or anyone else with more understanding than me) can you explain how you get this:-

What's interesting to observe is that, '87 crash excepted, volatility (as expressed by the width of the SD cone) does seem to trend over multi-year periods. It's hard to escape the conclusion that even when things "normalize", markets will carry a significantly higher risk premium than they have over the past few years

Thanks..PB

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Macro Man
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October 30, 2008 at 10:41 AM ×

The theory is simply that in periods of higher volatility, markets will demand higher risk premia to compensate for the volume of "noise" in price action.

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October 30, 2008 at 2:21 PM ×

Very Educational post... on Bear Rallies.. the members of myinvestorsplace.com feel this is a bear market rally...or a ball simply just bouncing after falling so much... time will tell...Really great post... maybe you can post at Myinvestorsplac.com...I am sure the members would love to learn from you...thanks

Andy

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prophets
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October 30, 2008 at 2:21 PM ×

MM - I saw larry lindsey on squawk box (US) this AM and he mentioned that the savings rate would approach 4%+ (from 0 today). I was wondering if you have any forward forecasts on GDP based on potential savings rate and corresponding consumer retrenchment outcomes/scenarios. or maybe just your 2 cents on what it means for US GDP in total.

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Steve
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October 30, 2008 at 6:58 PM ×

Great charts, thanks MM.

To me that period of calm during the period leading up to this current, uhm, period of stress was the sound of leverage being increased. Calm markets led to lower returns for any given level of leverage, which led to more leverage=>more buying, which lowered volatility even further.

I sit near some convert guys who tell me that even with 200% leverage they were working to make libor + 4%. If you wanted to go for double digit returns you had to leverage further, and lo and behold the HFR index shows a convert loss of 50% this year.

Just be happy you're not Convert Man...

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Macro Man
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October 30, 2008 at 7:09 PM ×

Prophets, I, too, expect the savings rate to rise substantially after falling a straight line for a quarter century. The implication? Less consumer spending and lower growth (though net exports will mitigate some of the impact.) Combined with waning trend productivity growth, it means that the speed limit (and by implication, earnings power) of the US economy is lower than most of have have become accustomed to.

Steve, I am, mate, I am. I call coupon-clipping instruments (that typically require high leverage) "turds" for a reason. "Turd Man" just doesn't sound as good as Macro Man, now doest it?

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prophets
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October 30, 2008 at 8:29 PM ×

MM-

Yea, I was kind of hoping you had some good math behind the prospective GDP figures for the US.... so I wouldn't have to do it myself :)

I will try to put something together this weekend when I catch up on my econ work. thx for your 2 cents.

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triozyg
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October 30, 2008 at 10:37 PM ×

Great charts MM

PB's question (10:31am) and your answer (10:41am) were particularly illuminating -- makes me wonder if the gaping hole opening up right now will be like the madness of the great depression or something more contained (and we all know how predictions of containment have worked out)

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Rich
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October 31, 2008 at 12:57 AM ×

One cause of illiquidity in the markets has been the increasing need to post variation margin for long positions. The current rally will reduce this need, and end the self-reinforcing nature of the downmove.

Many investments have become seriously cheap. I doubt that the past weeks selling with gusto was done by anyone other than the margin clerk. This bounce may have much stronger legs than you can imagine.

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Anonymous
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October 31, 2008 at 2:09 PM ×

MM as you seem to enjoy thinking out of the box, would you share some thoughts about feasibility of an ISK like fate for CHF ?
Swiss govt does not have the resources to offer protection of the amount of "savings" there. Also german authorities expose an unsual confidence lately to attac Swiss tax heaven...

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Macro Man
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October 31, 2008 at 2:13 PM ×

I have heard some mumblings and grumblings in that direction. I think it is unlikely, given that Switzerland is much more important to the global financial system, and thus much more likely to receive early and substantial aid from afar, tax squabbles de damned. The fact that EUR/CHF has "done what it says on the tin" by mirroring the SPX this month suggests that for now, fears over der Schweiz are misplaced.

Doesn't mean it won;t hurt if UBS goes "bang" however....

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