The Company You Keep

Holmes is back in Europe this morning, enjoying a well-earned break. It seems as if Hank and his European counterparts were busy as Holmes and Watson traveled back to London, as the past 48 hours have seen a swathe of capital injections and deposit/debt guarantees on both sides of the pond. Macro Man will leave it to others to sift through the proposals; suffice to say that injecting equity capital directly into banks is a far more efficient solution to simply buying turds off of them.

The news has obviously had a beneficent impact on equity markets, and most major indices have put in a year's worth of rally in the span of two trading days. Such conditions are not, ahem, normal, and Macro Man is frankly pretty happy to have risk dialed right down at the moment.

It's said that you can tell a lot about someone by the company he keeps, and the same is true of financial markets. The extreme price moves of the last few days are fairly historic in nature; small wonder, given that a day's price action is what an index could reasonably be expected to gain or lose in a year. By way of perspective, yesterday's rally in the Dow would be in the top half of yearly performances since 1922, coming in 42nd place.

Drilling down into daily data, the recent extreme swings in US equities- both down and up days- are close to unique over the past 80-90 years.

There are essentially two kinds of markets that resemble the last month or two: 1987, and the stock markets of the Great Depression.






































Judge for yourself which, if either, is the appropriate historical analogue. Certainly some aspects of the newsflow suggest the latter environment is closer to today. If that's the case, then we should probably expect the sky-high vol environment to continue.

More immediately, where to from here? Macro Man is left scratching his head. The Eurostoxx, for example, as already re-traced nearly 50% of its collapse since the beginning of September. 3 month Euribor, which fixed lower by 8 bps today, has retraced 38% of its move from the same period. Given that the latter has, ultimately, been the driver of the former, it's probably safe to say that equities are now pricing in a lot of the good news. There's still the small matter of a global recession to navigate in the quarters head....
Regardless of where equities go from here, it's safe to say that the stress of the past few weeks have created some strange bedfellows. The chart below shows the S&P 500 overlaid with the gold:oil ratio, which in normal may not mean very much but in times of stress represents some measure of the divide between fear and greed. As you can see, there has been a virtual 1:1 correlation between the two in recent weeks.


Frankly, Macro Man isn't sure what it means when equities and gold/oil keep such close company, other than "financial markets have been buggered". Anyone with a deeper insight is welcome to share it....as we begin the stretch run to the end of the year, Macro Man's mind is officially open to new trading ideas...
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Anonymous
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October 14, 2008 at 11:35 AM ×

Where did you get your percentages from MM? They don't match the official numbers at all:

http://online.wsj.com/mdc/public/page/2_3047-djia_alltime.html

Using the official numbers (before Monday's gain) finds some strange results. The Dow had fallen 500 points nine times, but had never risen 500 points.

Nothing ususual there, but much more oddly, the Dow had fallen more than nine percent only four times - 1019 in 1987, and 1028, 1029, and 1106 in 1929, but the Dow had RISEN more than nine percent on twelve different occasions.

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Anonymous
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October 14, 2008 at 11:46 AM ×

Bull spread VIX options and exchange equity?

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October 14, 2008 at 11:46 AM ×

Hi MM,

The gasp of relief is audible throughout, especially with all the previous blather about the EU being incapable of action. Unfortunately, the only problem that might have been solved is that equities might have been saved from fallng to zero. There's still alot of turf on the downside without it coming to that and my guess is it resumes going there sooner than we might think. It would be beneficial for all if a few banks fessed up and accepted capital injections pronto so that we can at least dream that the plan is appropriate.

All of the anti-dollars look interesting, almost regardless of outcomes and especially if the fear of being sideswiped by discrete events diminishes.

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October 14, 2008 at 11:49 AM ×

...and agree with anon#2. The buying of protection has reached bubble proportions.

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Anonymous
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October 14, 2008 at 11:54 AM ×

MM,
I suppose an explanation could be this:

Gold and oil have decoupled recently. The correlation from May to July 08 was more than 50%, but from August to now, it's been -2%.
Instead gold has in general moved in an inverse relationship to the stock markets. As stocks fell, oil fell as well, I guess on worries about reducing demand because of recession, etc. Meanwhile gold rose, probably because of "safe-haven" demand - so the oil/gold ratio decreased along with the S&P.
There are probably lots more levels to this, eg as the S&P sank, the chances of a rate cut rose so gold also rose as an inflationary hedge, etc etc.
Does this seem sensible?
Cheers
CT

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Anonymous
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October 14, 2008 at 12:36 PM ×

Oil producers accumlating gold instead of dollars going forward?

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Anonymous
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October 14, 2008 at 1:02 PM ×

I'm hardly an expert in the markets, but one thing I've read is that in a deflationary environment, i.e. in the great unwind, all asset classes lose value. Funds dump gold positions like positions in commodities, equities, and bonds. If we're seeing the bursting of the us treasury bubble, we could be seeing the burst of the gold bubble, too, at least until there's sufficient air taken out to relieve pressure in a situation where capital is scarce.

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Macro Man
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October 14, 2008 at 1:16 PM ×

Anon @ 11.35, I always calculate lognormal returns rather than simply arithmetic returns. In normal circumstances the difference is minimal, but when price moves are large there can be a substantial difference.

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SBG
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October 14, 2008 at 1:56 PM ×

What has been intertesting is that gold has yet to break its Sept. high much lees its July high. I would have expected with the panic more money would have rushed into gold. Maybe I should consult with my local package and arms shop as to how much money ran into spirits and bullets.

With all the liquidity being forced fed into the system I expect the inflation trade to rear its head again.

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Mark
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October 14, 2008 at 2:25 PM ×

Implied inflation in the US? US 5-year inflation is 30bp and I don't believe this can go negative. Thoughts?

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Anonymous
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October 14, 2008 at 2:34 PM ×

how come I am not comfortataded by the fact that the larger updays all occured during the great depression--bear squeeze are the biggest moves up and if i can judge by my neighboors talking about how right jim cramer was yesterday i feel quite good about selling with both hands right now--and you are right even though i run a macro fund might as well just trade s&ps everything else moving off of that and valuation and anything anyone else learned with an mba or cfa chuck out the window--phscy 101 about all that matters at the moment

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D
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October 14, 2008 at 2:36 PM ×

i've been short gold for about a week now. Long the N100 as well...profits on both and ownership in this market is always tentative.

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Macro Man
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October 14, 2008 at 2:48 PM ×

Mark, US inflation at those levels is indeed intriguing, but security selection is important. TIPS include a 100 put on the CPI index at maturity, so it is true that freshly issued securities cannot give u negative inflation compensation if held to maturity. Of course, if you buy an "old" TIPS, where the CPI index is, say, 130, you can indeed accrue negative inflation comp, as your CPI put is 30% away.

There is no such put at all in JGBis, and they are trading breakevens of -175 bps now. Ouch!

D, in markets as in property, now is a great time to be renting. (disclaimer: I own my house)

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D
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October 14, 2008 at 2:58 PM ×

trump is offering 20% off on 3500 sq. foot condos in Chicago with the good north-facing view on the upper floors! Trump seeking to sell the commercial floors of the building now.

Shangri-La tower halted in chicago also.

deflation...embrace it!

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D
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October 14, 2008 at 2:59 PM ×

trump isn't advertising that, but that's what came out of a discussion with them two weeks ago...no arm twisting required and no checkbook waving!

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mikarsky
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October 14, 2008 at 3:32 PM ×

It's good to see a bit of the nervousness going. But if the US further deteriorates, its debt that's sitting around the world will cause further havoc.

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Basti
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October 14, 2008 at 3:58 PM ×

Macro,

Gold is just another asset. As financials get pummeled money supply dwindles so all asset prices go down.

Best

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Anonymous
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October 14, 2008 at 4:22 PM ×

Would anyone (MM?) kindly point me to some scholarly reference on the mechanism of TIPS (such as its implicit Put on CPI) - need education here..

TIA.

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Anonymous
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October 14, 2008 at 4:54 PM ×

Just prognosticating here, physical gold is a hedge against financial disaster while gold futures is a financial instrument. So going forward, shouldn't we be seeing a dislocation between the spot and futures price.

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Anonymous
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October 14, 2008 at 5:08 PM ×

TIP breakevens have nothing to do with inflation, even though the CNBC crowd likes to pretend they do.

1) The BLS explicitly states that CPI is a price index, and **NOT** a measure of inflation. Prices can increase (or decrease) due to infrastructure/supply issues *or* from monetary inflation

2) The definition of CPI has not been constant over time -- the BLS has changed the definition several times. There is no reason to think it will not change it again in the future. This dilutes (and some might say eliminates) the price inflation protection that TIPs might otherwise provide.

3) TIPs are really just CPI indexed floaters that happen to be issued by the Treasury. They have a significant liquidity discount (they are no where near as liquid as nominals). This means that even if CPI were a good inflation indicator, TIP breakevens are a very biased estimator of future CPI.

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Anonymous
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October 14, 2008 at 5:18 PM ×

Good strategy for year end/09 imo: covered calls. There are several stocks for which you can sell a jan10 100% otm call for 30+% of the current stock price. For the large number of stocks that are ridiculously cheap, that presents very attractive risk reward.

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Anonymous
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October 14, 2008 at 6:36 PM ×

On the divergence between spot and futures that someone points to above, that's already happening, it seems, no?

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Manc Trader
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October 14, 2008 at 7:14 PM ×

Havn't got a clue but feel the best explanation is the dollar/yen deflation versus asset class inflation that minyanville talks about.
Basically we toggle between deflation and inflation with assets gold/commodities/short dollar/equitities trading as monolith when in asset inflation mode. Of course, there is a zero sum game between them so in any given rise some do better then others.
Then when debt deflation takes over dollar and yen take over and the rest are trade down. At some point one or other metod of debt destruction will take over and the change in the social mood from extreme debt fueled consumption to austerity argues for a continued period on the deflation side of the wishbone.
I think they have a good handle on this situation I am just happy to have sold my trading longs for a profit and live to fight another day.

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Anonymous
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October 14, 2008 at 9:24 PM ×

"Just prognosticating here, physical gold is a hedge against financial disaster while gold futures is a financial instrument. So going forward, shouldn't we be seeing a dislocation between the spot and futures price."

That we are: the bullionvault spot bid physical price is $8/oz over what one would expect due to 'great demand'. Even larger premiums on coins (eg kitco).

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October 15, 2008 at 12:32 AM ×

anon,

Interesting observation on the BullionVault spot price. Of course, the spread there is fairly wide already. There could be a lot of bottlenecks that could cause a premium, as with the coins.

And James Turk says, or at least said four days ago, he is still able to get LBMA bullion in London without paying a premium. Unless I'm totally wrong about how the gold fixing works, this should be a tautology - LBMA is a pure physical market and cannot default. So its "spot" should really be "spot."

Comex and LBMA trade at different hours, so it is hard to tell if there is any real tension developing between the two. Perhaps more telling is Comex vs GLD, and I don't see any consistent physical premium developing there. But of course, there is external arbitrage that ties the two, as well as the fund managers' buying and selling.

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Caprica
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October 15, 2008 at 4:25 AM ×

One up day does not mark the end of a trend. It can however mark the start of a dead cat bounce.

If in the next few days one major bank or finance institution fails, we will see an even bigger slide over the next few days and macroman will need to update his tables with a new date at the top of the 10 worst days ever.

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