Outperformance By Low Volatility Equity ETFs

Saturday, August 11th, 2012

by Richard Shaw, QVM Group, LLC

Over long periods, low volatility stocks have produced both a higher total return and lower volatility (better risk adjusted return and higher absolute return) than broad indexes. This is referred to as the “low volatility anomaly”, because it is contrary to the long held view that more return only comes from taking more risk. There are various theories as to why the anomaly exists, but factual evidence shows that it does.

Over shorter periods, low volatility does not always outperform. No approach always outperforms. As a generality, low volatility tends to lag in rising markets (captures less of the upside move), but to lead in falling markets (captures less of the downside move). Over cycles, that has come out ahead.

These histograms, using Morningstar Principia data, shows the three key US low volatility ETFs (SPLV, USMV and LVOL) versus the Russell 1000 index ETF (IWB) for total return and for upside and downside market move capture within the past 12 months ending July 31, 2012.

click image to enlarge

Two of the low volatility funds outperformed the Russell 1000 YTD and the low volatility funds outperformed the Russell 1000 over 1 month, 3 months and 12 months.

click image to enlarge

In the past 12 months, the Russell 1000 (IWB)captured 99.10% of the upside movements of the S&P 500 (did a bit better), and captured 104.77% of the S&P 500 downside movements (did worse). The two low volatility ETFs with 12 months of history (LVOL and SPLV) captured 71.81% and 64.92% respectively of the upside, and captured 7.58% and 54.71% of the downside, according to Morningstar, [the 7.58% downside capture figure for SPLV seems like it may be an error, but we expect the capture was lower than the Russell 1000].

The trailing yields on each of the three funds with 12 months of history are:

• IWB: 1.84%
• SPLV: 2.68%
• LVOL: 1.91%

The assets in each fund are:

• IWB: $6,395.2 million
• SPLV: $2,326.7 million
• USMV: $342.0 million
• LVOL: $67.9 million

Here are some key valuation metrics for the four funds:

Standard and Poor’s Had This To Say and Illustrate About the Low Volatility Anomaly: (download their report)

“With so much uncertainty in riskier investments, many investors are seeking calmer waters for at least a portion of their portfolios.

The S&P 500 Low Volatility Index comprises the 100 least-volatile stocks in the S&P 500.
Volatility is measured as the standard deviation of price changes over the trailing 252 days. The 100 securities are then ranked and weighted according to their volatility, with higher weights assigned to less-volatile stocks. The index is rebalanced quarterly. Historical data shows that an index comprising low-volatility securities outperform more-volatile securities by providing better downside protection during volatile periods while offering favorable relative annualized returns.

Lower Risk Doesn’t Mean Having to Settle for Lower Returns
Getting better returns without taking higher risks may seem counterintuitive. However, the simple, yet powerful low-volatility investment approach has resulted in higher relative performance compared to the parent index over a long-term period.

In terms of annualized, risk-adjusted returns, the S&P 500 Low Volatility Index outperforms the S&P 500 over near-, medium- and long-term investment horizons.”

The real world problem illustrated by the chart above is that many (perhaps most) investors would have abandoned their low volatility stocks, or fired their low volatility oriented investment manager in the late 1990s due to underperformance, not seeing the outperformance ahead.

Standard and Poor’s Release An Updated Low Volatility Study in August 2012 (download report)

They said,

“Among the long-standing anomalies in modern investment theory, perhaps none are as puzzling and compelling as the low-volatility effect. It challenges the traditional equilibrium asset pricing theory that an asset’s expected return is directly proportional to its beta or systematic risk, or, in other words, higher-risk securities should be rewarded with higher expected returns while lower-risk assets receive lower expected returns.

Contrary to that theory, the empirical evidence of numerous academic studies has illustrated that low-volatility or low-risk investing outperforms the broad market as well as high-risk strategies over a long-term investment horizon with much less realized volatility. In the U.S. equity market, the S&P 500 Low Volatility Index returned 6.95% (10.75% standard deviation) and the MSCI USA Minimum Volatility Index returned 5.1% (12.32% standard deviation) on an annualized basis over the 10 years ended March 31, 2012, with 23% to 30% lower volatility than a market cap-weighted benchmark such as the S&P 500, which returned 4.12% (15.99% standard deviation).”

Russell Investments Says This About the Low Volatility Anomaly: (download their report)

“Intuitively, investors might expect stocks that are less risky than other stocks – stocks we refer to as defensive stocks – to deliver lower returns than the broad market over the long term. … Key findings from the academic research: no evidence of a risk premium for risky stocks.”

They provide this chart hat shows lower return for higher volatility (a higher return for lower volatility) for investments in US stocks from 1986 through 2006.

Copyright (c) QVM Perspectives

Tags: Absolute Return, Anomaly, Downside, ETFs, Factual Evidence, Generality, Group Llc, Histograms, Iwb, Long Periods, Lvol, Market Move, Morningstar Principia, Outperformance, Qvm, Richard Shaw, Risk Adjusted Return, Shorter Periods, Volatility, Ytd
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Rosenberg On The Pending Trade Shock and Q4′s GDP Growth Outlook

Wednesday, August 8th, 2012

It would appear that the dilemma of the world exporting more than it imports (that we initially pointed out here) is starting to come to a head in reality with a negative export trade shock. As Gluskin Sheff’s David Rosenberg notes, since the recovery began three years ago, over 70% of the real GDP growth we have seen was concentrated in export volumes and inventory investment; and recent data from the ISM (here and here) points to a dramatic slowdown in both. Compounding this weakness is the fact that the remaining growth was from Capex – which is now likely to slow given the weakening trend in corporate profits – and will more than offset any nascent turnaround in the housing sector – if that is to be believed. The consumer has all but stalled and adding up all these effects and there is a high probability of a 0% GDP growth print as early as Q4.

Macro Risks Squarely To The Downside

I think that there may be a time, before too long, when we will walk into the office to find that the US prints a negative GDP reading on the back of a negative export trade shock that does not appear to be in any forecast – let alone consensus.

Look at the pattern of ISM export orders:

• April: 59.0
• May: 53.5
• June: 47.5
• July: 46.5

That is called a pattern. And this is a level that coincided with the prior two recession. As the chart below vividly illustrates, there is a significant 81% correlation between annual growth in total US exports and the ISM new orders index (with a four month lag). So either the market has already priced this in or it is going to end up coming as a very big surprise. We are already seeing the lagged effects of the spreading and deepening European recession hit Asian trade-flows: Korean exports sagged 4.1% in July after a 3.7% slide in June and are down 9% on a YoY basis. Industrial production there edged lower by 0.4% as well last month – I like to look at Korea since it is a real global ‘play’ on the economic cycle.

There is likely going to be another surprise, which is inventory destocking. How do I know that? Because the share of ISM industries polled in July reported that customer inventories were excessively high soared to 33% in July from 11% a year ago (because this metric is not seasonally adjusted it can only be assessed year-on-year), the highest ever for any July in the historical database.

Add to that what is happening to order books – the share of the manufacturers reporting expanded orders sank to 17% in July from 50% a year ago and again – the worst July showing on record.

The food price situation is another major wild card, especially since whatever relief we enjoyed from lower gasoline prices is now behind us. At a 14% share of the consumer spending pie, only shelter is more important than food. And when you go back to the last food cost surge, in the first quarter of 2011 when the grocery bill soared at a punishing 10% annual rate, real GDP growth slowed to a 0.0% annual rate that quarter, which arguably was the big surprise of the year (up until the dent downgrade, that is).

In the final analysis, since the ‘recovery’ began three years ago, over 70% of real GDP growth we have seen was concentrated in these two areas: export volumes and inventory investment. The rest was in capex which is now likely to slow along with the weakening trend in corporate profits, more than offsetting the nascent turnaround in the housing sector. Also keep in mind that the consumer has stalled.

Tally all these effects up and you are looking at the prospects of 0% growth as early as Q4.

Tags: Asian Trade, Capex, Corporate Profits, Correlation, Dalio, David Rosenberg, Downside, Dramatic Slowdown, Export Orders, Export Trade, Export Volumes, GDP, GDP Growth, Gluskin Sheff, Growth Outlook, Inventory Investment, Ism, Korean Exports, Real Gdp, Recession, S David
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Europe Is Japan? Goldman Expects ECB To Become The BOJ, Purchase Private Assets

Monday, July 30th, 2012

Goldman’s ex-employee Mario Draghi is in a box: he knows he has to do something, but he also knows his options are very limited politically and financially. Yet he has no choice but to escalate and must surprise markets with a forceful intervention as per his words last week or else. What does that leave him? Well, according to Goldman’s Huw Pill, nothing short of pulling a BOJ and announcing on Thursday that he will proceed with monetization of private assets, an event which so far only the Bank of Japan has publicly engaged in, and one which will confirm the world’s relentless Japanization. From Pill: “Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed.” Why would the ECB do this: “A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations.” In other words, the only thing better than a little global central banker put is a whole lot global central banker put, and when every central planner is now all in, there is no longer any downside to putting in even more taxpayer risk on the table. Or so the thinking goes.

Of course, a rational person may wonder: why would the ECB, which a week ago was arguing for impairing senior debt, suddenly go ahead and monetize not only senior but subordinated debt. And one step further, one may also wonder if this is merely the latest iteration of a Goldman call that should be faded. Because if so, the market is in for a rude awakening. Alternatively, if Draghi does go the full Shirakawa, expect merely a brief LTRO-type response higher, to be followed by yet another major swoon lower as the drug addict demands more, more, more, only that more no longer exists with each succeesive asset dilution iteration.

From Goldman:

We forecast that the ECB will permit NCB purchases of private sector assets

ECB President Draghi’s comments in London last week have raised market expectations that important new measures will be announced by the Governing Council on Thursday (August 2).

Were the Spanish government to request support from the EFSF ahead of Thursday’s meeting and accept the implied conditionality, we would expect the ECB to offer significant support to sovereigns, including through outright ECB purchases of government debt via the SMP. This would mark a significant acceleration and intensification of what we have previously forecast. However, our base case is that events will not move so quickly: the Spanish government is pre-funded through October and, according to the latest reports, an immediate Spanish request to the EFSF is unlikely. We do not expect the ECB to move unilaterally: we view explicit and concrete political support for its actions via EFSF conditionality as a prerequisite for an extension of support to the sovereign markets.

The ECB therefore risks disappointing heightened expectations. Bringing forward measures to ease private-sector financing conditions in the periphery is a likely response. Well-flagged possibilities in this regard include a further easing of collateral eligibility standards and new longer-tenor refinancing operations. But precisely because these measures have been anticipated, they are unlikely to satisfy the market expectations raised by Mr. Draghi’s comments. And we would in any case view the  effectiveness of such measures as questionable, given the segmentation of financial markets and dysfunctionality of financial systems in the periphery.

Given the (to us) surprisingly bold tone of Mr. Draghi’s comments last week, we nevertheless think a new initiative may well be in the offing. We have argued in the past that the next step in the escalation of the ECB response would be outright purchases of private assets. Acting in this direction on Thursday would represent a significant event. We forecast the announcement of measures to permit NCBs to purchase private-sector assets under their own risk to implement ‘credit easing’, within a general framework approved by the Governing Council. This would allow purchases of unsecured bank debt and corporate debt, enabling NCBs to ease private-sector financial conditions where such support is most needed. Progress in centralising banking supervision at the ECB would facilitate such support for the banking sector.

1.Market tensions continue to mount in the Euro area, in an environment of ongoing macroeconomic weakness.

2.Thursday’s comments by ECB President Draghi in London have raised expectations that the ECB will resume purchases of peripheral sovereign debt via its Securities Markets Programme (SMP). Peripheral markets have rallied as a result.

3.Anything short of an announcement of such a resumption at next week’s ECB Governing Council meeting risks disappointing markets. Indeed, expectations have been raised further on reports that a package of additional measures (interest rate cuts, new liquidity operations) is being prepared in parallel for the August 2 ECB monetary policy meeting.

4.Thus far, we have assumed that the European Financial Stability Facility (EFSF) would be the authorities’ first line of defence in addressing sovereign market tensions. We continue to hold this view. Moreover, we anticipated that the ECB would act in a supportive manner towards sovereign markets should the EFSF take up its responsibility in this regard, for example by offering another longer tenor LTRO operation on a fixed rate / full allotment basis (thereby supporting Euro area banks’ purchase of peripheral sovereign debt). We also continue to hold this view. And recognising the limited capacity of the EFSF / ESM, we have assumed that ultimately the ECB’s balance sheet will need to be mobilised to fund financial support for vulnerable Euro area sovereigns. Our view here is also unchanged.

5.How then to interpret the (to us) surprising boldness of Mr. Draghi’s remarks in London last week? We see them as reflective of an accelerated pace of events, rather than a fundamental change of character. We organise our further analysis around two possible explanations for this acceleration: (a) that Mr. Draghi expects an imminent Spanish request for EFSF support, and therefore foreshadows ECB action as part of a more comprehensive policy response; and (b) that Mr. Draghi’s concerns about contagion and spillovers from sovereign funding tensions in Spain have become more acute.

The Spanish are coming

6.We had been working on the assumption that – with the Spanish sovereign pre-funded for several months yet – we would not see Spanish recourse to the EFSF until the early autumn, as the usual political prevarication prevailed.

7.Mr. Draghi was clearly aware of the market expectations he was creating last week; hence, his comments might suggest he is confident that the Spanish government will turn to the EFSF sooner than that, opening the way for new ECB actions in the coming weeks. Comments from the German and French governments in the aftermath of Mr. Draghi’s remarks, which point to the EFSF as the vehicle for addressing market tensions, would support this view.

8.We continue to doubt the ECB will act ahead of a Spanish request for EFSF support. A unilateral reactivation of SMP purchases of sovereign debt by the ECB in the form seen on past occasions risks being not only ineffective, but even counterproductive – for all the usual reasons:

• As Friday’s statement from the Bundesbank demonstrates, its resistance to central bank purchases of peripheral sovereign debt remains strong. The Bundesbank is not alone. Reigniting discord within the ECB’s decision-making bodies by restarting the SMP threatens to disrupt once again the ECB’s capacity to act on this and other dimensions of policy. And such discord inevitably implies commitment to such interventions is somewhat ambiguous, thereby undermining their effectiveness;
• Given how ECB holdings were treated in the Greek debt restructuring, subordination concerns understandably persist among market participants. Declarations of a willingness to take losses on SMP holdings ring hollow: actions speak louder than words in this context. While the ECB may have the opportunity to demonstrate such willingness sooner rather than later in the Greek context, the effectiveness of unilateral SMP purchases is questionable: they need to encourage rather than deter the natural longer-term holders of peripheral sovereign debt from re-entering this market;
• Above all, were the ECB to restart SMP purchases unilaterally, the incentive for the Spanish government to seek EFSF support – and accept the implied conditionality – would be reduced. An opportunity to hardwire the necessary consolidation, reform and adjustment into the institutional system would be lost. Broadly speaking, we take a positive view of the Spanish government’s policy programme. While we see scope for accelerating and deepening structural reform, if anything we view their envisaged fiscal adjustment as possibly too aggressive. But these measures have not arisen spontaneously: they have come in response to market pressure. For market pressure to be relieved by external financial support, we view the introduction of greater conditionality as crucial to maintain the momentum of adjustment.
• More generally, it has been a long-held ambition of the ECB to ensure governments have explicit financial involvement with regard to peripheral sovereign debt purchases via the EFSF, rather than leaving the ECB to take sole responsibility. And involving the EFSF introduces the necessary formal conditionality and political accountability to the process, which – as last year’s experience in Italy demonstrates – the ECB acting alone lacks.

9.As we have argued in the past, such concerns make us even more sceptical of proposals to cap peripheral sovereign yields or  target spreads through an ECB commitment to potentially unlimited SMP purchases of peripheral government debt. Market participants seek the certainty offered by such an unconditional commitment to stabilise yields. Given the multiplicity of uncertainties they face at present, that desire is understandable. But such an unconditional commitment by the ECB renders public budget constraints very soft. Irrespective of their behaviour, governments are able to borrow at the rates pegged by the ECB, serving to create moral hazard and scope for ‘free-riding’ on others’ disciplined behaviour.

10.For the ECB in the current environment, this tension between satisfying markets and constraining government is inescapable. It lies at the heart of the difficult course the ECB has charted throughout the financial crisis. Managing the trade-off entails offering external financial support to governments in return for their acceptance of conditionality. Hence, involvement of the EFSF to provide political legitimacy to that conditionality appears crucial.

11.All this leaves the initiative for triggering the next steps in the hands of the Spanish government. Should a request for EFSF support be forthcoming ahead of or in parallel with the ECB Governing Council meeting next Thursday, it would open the door for the ECB to announce supportive measures on that occasion.

12.As we have said in the past, in parallel with EFSF purchases of Spanish sovereign debt subject to adherence to the conditionality expressed in the required Memorandum of Understanding (MoU), we would expect the ECB to support sovereign markets through a repeat of the longer-tenor LTROs that served this purpose earlier in the year. These fund banks to buy domestic sovereign debt in the primary market (where the ECB is prohibited by the Treaty from operating directly). The latest data reveal greater reluctance on the part of Spanish banks to increase their holdings of sovereign debt, while Italian banks continue to show a willingness to do so. In the former case, some ‘arm twisting’ may be required to ensure demand at sovereign auctions, but with public ownership of the Spanish banking sector on the increase, this should be possible.

13.Moreover, recognising the inadequate capacity of the EFSF in the face of sovereign tensions in Spain and / or Italy, we have argued that ultimately – and probably sooner rather than later –the ECB will be drawn into funding that vehicle. With  considerations in the German Constitutional Court delaying the introduction of the EFSF’s permanent (and slightly larger) successor (the European Stability Mechanism, ESM) until at least mid-September, this concern will be particularly acute in the coming weeks.

14.We have always argued that the typical characterisation of how this funding would be provided – giving the EFSF / ESM a banking licence – was an unnecessarily clumsy and provocative route in the face of the well-known institutional and political sensitivities. Admittedly, having the ECB make outright government debt purchases via the SMP in parallel with EFSF / ESM interventions (as envisaged above) is not much (if any) better in this regard, but nevertheless has returned to the discussion. A less controversial scheme, perhaps involving the publicly-owned development banks of the larger Euro area countries, could be found. But these institutional and legal niceties should not detract from the underlying economic reality: one way or another, the ECB’s balance sheet has been and will be mobilised to support sovereign funding. As reflected in the preceding discussion, the crucial question concerns the terms on which this funding is provided.

Addressing contagion (1): Cross-country sovereign spillovers

15.All this assumes that Spain will request EFSF support. Yet German Finance Minister Schaeuble is reported on Saturday as saying a Spanish request for EFSF support is not imminent, as Spain does not face immediate funding problems. And in this Mr. Schaeuble is correct. Having taking advantage of the post-LTRO euphoria in the first quarter, the Spanish government has pre-funded itself, probably through early October. On Spain’s part, there is no urgency to seek external financial support.

16.But Spanish tensions have implications elsewhere. One rationale for immediate ECB action is to contain potential contagion across countries. After all, the introduction of the SMP back in May 2010 stemmed from the concerns that disorder in Greek sovereign markets was dragging down ‘innocent bystanders’ with more modest fundamental problems, simply because of adverse market dynamics. In his London remarks, Mr. Draghi appeared to endorse this line by reviving discussion of the need to re-establish an effective transmission of monetary policy throughout the Euro area.

17.Italy is the most pressing case in this regard. With a primary fiscal surplus, even from its initial high level of sovereign debt the Italian fiscal situation is sustainable – provided that outstanding debt can be rolled over at reasonable rates. But this crucial condition is not met in the current challenging environment. Political pressure is therefore building in Italy: despite accepting the pain of fiscal austerity (and suffering a deep and prolonged recession as a result), Italy has not been rewarded by the markets or by their European partners.

18.In his London comments, Mr. Draghi referred to the impact of ‘convertibility risk’ on interest rates, yields and financial conditions. These remarks are consistent with our own interpretation of recent developments: as the risk of Euro exit has mounted through the crisis, a redenomination risk has become embedded in some asset prices. Uncertain as to what a paper Euro-denominated asset originating from the periphery really represents, foreign investors have been unwilling to hold, still less buy, such assets – and peripheral financial conditions have tightened significantly as a result. Viewing the emergence of this redenomination risk as a systemic problem of which Spanish funding tensions are simply a symptom, one can argue that a systemic solution is required. However well Spain and Italy behave, they are victims of a systemic problem over which they have limited influence.

19.The impact of such systemic considerations could justify ECB actions to contain sovereign spreads. But unfortunately for ECB policy makers, spreads do not come with labels. As we have argued in the past with respect to the distinction between liquidity and solvency risks, a grey area exists between spreads arising from systemic risks and those coming from country-specific economic fundamentals. Attempts to cap sovereign spreads run foul of the dangers expressed above: while they can offset the impact of systemic risks beyond the country’s control, they can also induce free-riding and moral hazard.

20.Conditionality is therefore required. And that leads us back to the role of the EFSF/ ESM in providing the political legitimacy for such conditionality. In the end, the elimination of redenomination risk requires fundamental changes that prompt long-term private holders of sovereign debt back into peripheral markets. Introducing incentive problems makes achievement of that goal harder rather than easier.

Addressing contagion (2): Spillovers from public- to private-sector financing

21.Concerns about spillovers from Spanish sovereign funding tensions not only extend to other countries, but also to the Spanish private sector. Mr. Draghi’s remarks about the impairment of the monetary policy transmission mechanism reflect the extremely difficult financing conditions facing Spanish companies and households, and weak pass-through of official ECB rate cuts to the Spanish real economy. Our own recent analysis of the relationships among official interest rates, bank lending rates and sovereign yields support these concerns. And we have demonstrated that these concerns are not unique to Spain: similar issues arise in Italy and the rest of the periphery.

22.One approach to addressing this problem is to reduce the sovereign spreads that are associated with higher bank funding costs and financial market dislocations. SMP purchases of sovereign debt are a natural vehicle for the ECB to use in that context. But such an approach immediately runs into the problems identified above: the effectiveness of such interventions will be greater the less conditional they are, but the risk of free-riding by the fiscal authorities will be greater.

23.An alternative approach would be to bypass the sovereign spreads and support private-sector financing directly. With its broad and widening definition of collateral eligibility, purchases of bank covered bonds and 3-year LTROs, the ECB has already engaged in variants of this approach, a path now being mimicked by some other central banks. But scope exists to go further.

24.Collateral eligibility could be relaxed again and the haircuts imposed on collateral values reduced. Indeed, the ECB is already engaged in a review of its collateral framework: we anticipate that this will look to remove sovereign credit ratings from the system, in an attempt to eliminate the ‘cliff risk’ inherent in the current system. While the rationale for such a measure may be systemic, it is undoubtedly convenient in the specific circumstances faced by Spain now. And a review of the collateral system offers scope to make more aggressive easing measures elsewhere. Further longer-tenor LTRO operations could be envisaged, out to 5 or 10 years.

25.But, particularly in Spain, the efficacy of such measures is open to question. With the replacement of private unsecured financing with funding from the ECB’s 3-year LTROs against eligible collateral, assets on Spanish bank balance sheets have become encumbered. While bank funding at ECB operations is now cheap and readily available, insufficient free collateral is available to exploit this. Buying covered bonds – as the ECB has done in the past – does not help in this respect (as it also, by nature, involves encumbering bank assets), while changes in collateral eligibility and haircuts have a marginal impact.

26.Outright central bank purchases of unsecured bank debt – something that we have discussed previously – would address this issue. They would support banks’ balance sheet flexibility and facilitate the flow of credit to bank-dependent (and thus credit-starved) small and medium-sized enterprises (SMEs), particularly if marginal incentives were introduced to expand new credit and direct it towards SMEs. Of course, despite the recapitalisation scheme being put in place in Spain, other constraints (notably capital problems) weigh on banks’ ability to lend. And credit demand is weak. So such measures are not a panacea. But in a  bank-dependent economy where the traditional interest rate channel of monetary policy transmission is impaired by market segmentation, they may be the most effective tools available. And the prospect of assuming responsibility for banking supervision across the Euro area may make the ECB more willing to act aggressively through the banks.

27.Extending the chain of logic developed above, this would point to the desirability of bypassing not only the sovereign space, but also the banking system by buying corporate debt. Admittedly corporate debt markets in the periphery are underdeveloped. But were the ECB to initiate purchases, issuance would no doubt quickly follow. And financing the larger corporates that are able to issue would improve their working capital position and thereby indirectly ease financing pressures on their SME suppliers as payment periods normalise.

28.A natural objection to outright purchases of assets issued by the private sector is that they involve the assumption of too much credit risk by the ECB. But substantial risk is already assumed via credit operations. And, by their nature, credit easing measures involve the assumption of credit risk. The more aggressive the measure, the greater risk assumed. If – as the macro data suggest – Spain and Italy need substantial stimulus, then imparting that via credit easing means that a lot of risk will need to be taken. And given the present segmented state of Euro area financial markets, for a given willingness to accept risk, it may be preferable to make targeted interventions in the countries and sectors where tensions are most acute – even if this means the risks inherent in any single position is greater.

29.The risk assumed can also be distributed across countries in a politically acceptable manner. As with the risk associated with the national schemes for bringing unrated corporate loans as collateral introduced last December, one could envisage the ECB approving a set of voluntary national private asset programmes proposed by NCBs to reflect their particular circumstances, where the credit risk in those operations remained on the NCB balance sheet. Of course, this would not eliminate the risk faced by Germany and the Bundesbank: to the extent that such purchases create TARGET 2 balances (which is likely to be significant), the Bundesbank would still suffer losses in the event of Euro break-up or a peripheral country exit. But the idiosyncratic risks associated with an individual purchase (or indeed any cyclical or sectoral risk that does not lead to exit) would fall on the peripheral country alone, and not on Germany or other Euro area countries. (Of course, in some respects this is a disadvantage: only the ‘catastrophe risk’ is mutualised, but other forms of risk are concentrated at the national level. Thus the risk sharing benefits of a more integrated financial sector are forgone.)

30.Such a scheme allows NCBs to undertake quasi-fiscal action (since credit easing is a form of public subsidy) and monetise the fiscal consequences (by expanding their balance sheets). NCB purchases of private-sector assets (within a framework overseen by the ECB that leaves the credit risk inherent in such operations lying on the NCB balance sheet) offer scope for surgical interventions targeted to address the most impaired elements of monetary policy transmission, while limiting the potential adverse consequences for incentives (especially of governments). Cosmetically, such measures will add to the impression of a renewed Balkanisation of monetary policy in the Euro area. But, with Euro financial markets deeply segmented, such targeted measures offer a way of managing the consequences of that segmentation for the private sector and real economy while maintaining the pressure for governments to act on fundamentals in a manner that reduces and ultimately eliminates the segmentation over time.

Tags: Bank Debt, Bank Of Japan, Central Planner, Corporate Debt, Credit Operations, Credit Risk, Downside, ECB, Escalation, Goldman, Governing Council, Huw, Japanization, Mario Draghi, Monetization, Private Assets, Rational Person, Substantial Risk, Taxpayer Risk, Whole Lot
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David Rosenberg Explains the Housing “Recovery”

Thursday, July 5th, 2012

Confused by all the amusing arguments of a housing “recovery” (because if you believe in it, it just may come true…. maybe) in the sad context of a reality in which the economy is once again turning from bad to worse missing expectations left and right (for every report surprising to the upside, two do the opposite), corporate earnings and margins have rolled over, US states and cities and European countries are filing for default or demanding bailouts at an ever faster pace, and only headlines such as “stocks rise on hopes of more central bank easing” appear in the good news columns of mainstream media? Don’t be: David Rosenberg explains it all.

From Gluskin-Sheff

HOUSING DATA SKEWED BY “UPSIDE-DOWNERS”

What is really driving whatever recovery we are seeing in terms of home sales and prices are the units that are so ridiculously priced — like at less than $125,000. These are where the multiple offers are coming into the fore — and then to be rented out. The reason is that this is the only part of the market that is truly “tight” because almost 30% of American homeowners either have no equity in their homes or less than 5% skin in the proverbial game (according to CoreLogic). These folks have to write their lenders a cheque to make a sale, so many are holding out until they can get a better price and the all-cash deals being placed by investors are allowing for this (note too that 45% of the nation’s homeowners have less than 20% of equity in their homes).

According to data cited by the USA Today, the supply backlog where over half of homeowners are “upside down” on their mortgage is at 4.7 months’; in areas where “upside down” borrowers make up less than 10% of the market, the listed inventory is closer to 8.3 months’ supply — it is in this mid-to-high end where prices are still vulnerable to downside potential — this is not the sliver of the market where vulture funds are looking to pick up a cheap unit to then rent out to the “boomerang” crowd.

As the charts below visibly illustrate, it is probably a little early to be celebrating the recovery in the U.S. housing market, despite the exuberance in the homebuilding stocks which only capture a small share of the overall industry. The market is healing to be sure, but is far from healed. Look at these graphs and draw your own conclusions.

Tags: 7 Months, American Homeowners, Backlog, Boomerang, Borrowers, Cheque, Corporate Earnings, Crowd, David Rosenberg, Downside, Economy, European Countries, Lenders, Mainstream Media, Margins, Months Supply, Mortgage, Pace, Sliver, Stocks, Usa Today, Vulture Funds
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Three Years and Counting (Kashkari)

Thursday, June 14th, 2012

• In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.
• As heightened volatility persists, many equity investors remain on the sidelines. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.
• We believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term. Equity investors should continue to focus on
  higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

We recently concluded our Secular Forum, an annual event in which PIMCO investment professionals from around the world discuss and debate our three- to five-year outlook for the global economy and financial markets. The Secular Forum process demands that we focus on the long term and imposes a discipline on us that we believe makes us better stewards of our clients’ capital.

Mohamed A. El-Erian published a summary of our conclusions from the Forum, titled Policy Confusions and Inflection Points. And my portfolio manager colleagues are participating in a series of interviews discussing these conclusions.

My goal here is to discuss what our revised Secular Outlook means for equity investors. But first I think it is important to take a moment to review conclusions from prior Secular Forums and objectively consider what has actually happened in the intervening periods. What have we gotten right? What has surprised us?

In the spring of 2009, with the U.S. economy and financial markets still reeling from the financial crisis, PIMCO conducted its annual Secular Forum right on schedule. It was during this time that PIMCO first applied the term New Normal to its updated outlook for the global economy. It is important to note that I wasn’t at PIMCO at the time – I was still at the Treasury helping to fight the financial crisis. I only joined PIMCO six months after I left government.

As government officials consumed with trying to stabilize the global financial system, my colleagues and I were much more concerned about surviving the next few days or weeks than thinking about the next three to five years. It is noteworthy that an investment management firm had the poise to stop to think about the longer-term outlook during that stressful time.

The New Normal called for long-term deleveraging that would lead to lower growth than society had been accustomed to. It called for more modest investment returns across asset classes, as the leveraging of the economy reversed course. It called for increased regulation and reduced globalization. Most importantly, it said there would be no V-shaped recovery that is typically seen after a recession. It would be a long, hard adjustment period with sustained high unemployment. It also called for a transition of stress from private balance sheets to sovereign balance sheets.

These trends, unfortunately for societies, have played out as my PIMCO colleagues forecasted. I also observe that implicit in their forecast was the assumption that policymakers would be successful in stabilizing the financial system and preventing a collapse. In hindsight, they seem to have been more confident than we in government were at the time. I am glad they were right.

While this may seem self-congratulatory for me to pat my PIMCO colleagues on the back, as I noted above, I wasn’t at PIMCO at the time. I am just observing, with the benefit of hindsight, what has actually happened.

While PIMCO’s New Normal call has proven remarkably accurate, its implications for equities were less clear. PIMCO did not forecast that central banks would employ unprecedented aggressive monetary policy via quantitative easing with the specific goal of pushing up the prices of risk assets in an attempt to stimulate economic activity. The QEs have been effective in pushing up equities (see Chart 1 below) and staving off deflation, though the effect on real GDP is less clear. In addition, the New Normal did not forecast record corporate profits that many companies have enjoyed, especially large multinationals. In the past three years, equities have rallied more than the underlying economic fundamentals would have predicted on the back of extraordinary monetary policy activism and strong corporate earnings.

In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.

Chart 2 shows the VIX, or volatility index of the S&P 500 Index, over the past 10 years. You can see three fairly clear periods: “old normal,” financial crisis and New Normal. As the crisis has spread from corporate to sovereign balance sheets and from the U.S. to Europe, sentiment has repeatedly swung from fear to greed and back to fear, triggering wild swings in equity markets.

Many investors, both individuals and institutions, were truly shocked by the losses they experienced during the financial crisis: The S&P 500 fell 38% in 2008. After years of gains, many people couldn’t believe their nest eggs were being destroyed. This experience has left many investors both scared and scarred – and as heightened volatility persists, many equity investors remain on the sidelines.

Our updated Secular Outlook calls for a continuation of the deleveraging we’ve experienced for the past few years. Slow real economic growth in America of 1% to 2%, a likely recession in the eurozone stemming from the ongoing debt crisis, and – and this is really important – slowing growth in the emerging markets of 5%, down from 6% previously. Remember, emerging markets have powered the global economy for the past few years; the U.S. will have to carry more of that load now. But with more moderate overall global economic growth in the next three to five years, markets will be more vulnerable to shocks.

The volatility that equity markets have experienced in the last few years is also likely to continue for the foreseeable future. The crisis in Europe will take years to resolve in part because policymakers there are trying to simultaneously achieve multiple, often-divergent objectives: 1) preserve basic eurozone stability, 2) keep pressure on fiscal authorities to make hard choices and 3) keep inflation in check. These multiple objectives prevent them from taking final, decisive action to quell the crisis. Our base case outlook is continued spurts of crisis and volatility coming out of Europe. These policy and macro factors will likely continue to overwhelm company-specific factors in the short term.

Many investors aren’t sure what to do – where to turn for “safe” investment returns in light of this volatility. As I regularly meet with clients and financial advisors, I repeatedly hear a few questions about how to navigate these choppy equity markets that are worth discussing here:

Given the volatility of the New Normal, why should I invest in equities at all? Why shouldn’t I just sit in cash and wait it out?
Unfortunately the final end-state for the global economy following this debt-induced crisis is unclear. If the global economy faces deflation, sitting in cash or fixed income instruments will probably be the best option. Purchasing power will increase as prices fall. While a deflationary scenario is not impossible, it is the least likely outcome given central banks’ actions to date. More likely is a moderate inflation scenario. Sitting in cash in such a scenario will see purchasing power degrade due to inflation. Equities should perform well in a moderate inflation scenario. This is our highest likelihood outcome.

A high inflation scenario can’t be ruled out either. It is possible that central banks could lose control of inflation expectations. In such a scenario cash and bonds will likely perform the worst, with equities next. Real assets and commodities would likely perform best, because prices for those assets should rise with inflation.

Because of the uncertainty regarding the end-state of the global economy and the fact that the only scenario in our view where cash performs well is the least likely, deflationary scenario, sitting on the sidelines is unfortunately not a good option for those who have future liabilities they need to meet. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.

Given our outlook that moderate inflation is the outcome with the highest long-term probability, we believe equities should be a meaningful part of a diversified investment portfolio. Equity investors should continue to focus on higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

My clients just can’t take the equity market pullbacks. What should I do as a financial advisor?
Many clients are in this situation. From May 2002 to May 2007, during the old normal, the S&P 500 experienced a 5% correction from a recent high five times, or on average of once per year, and a 10% correction four times. In the three New Normal years from May 2009 to May 2012, the S&P 500 experienced seven 5% corrections, more than twice as often, and a 10% correction three times. This increased downside volatility not only has direct financial implications for clients, but also has indirect effects that are important too: The emotional swings are scaring clients into sitting on the sidelines. As discussed above, this could prove very costly if central banks are successful in engineering moderate inflation, let alone high inflation.

We believe clients and advisors should focus on strategies that can be used to manage downside volatility. There are a number of ways to pursue this: 1) Buying higher-quality companies and those with strong balance sheets, because they tend to be more resilient against shocks, according to our research. 2) Buying companies at deep discounts to their intrinsic value. 3) Buying companies offering more immediate return on investment through dividends. 4) Actively hedging the portfolio, with tail risk hedging (which refers to taking a defensive position against extreme market shocks), or other means. 5) Investing in multi-asset solutions that provide diversification and include equities, fixed income securities and commodities in one vehicle.

Is passive or active management better in this environment?
We believe there is a place in client portfolios for both passive and active management. Each has advantages. Passive management tends to be cheaper than active management. But with each pull back in the equity markets, a passive strategy should fall in lock-step with the market. Passive index replication, by definition, has no downside protection against market moves. If clients are alarmed about market corrections, passive management won’t help them. A related point that I have written about previously (Teaching to the Test – September 2011) is that many managers associate index investing with taking less risk. Index investing is taking no benchmark risk, but clients are still taking risk – as the S&P 500’s 38% loss in 2008 so painfully reminds us.

We believe active management should aim to provide clients with a better experience. That means enabling clients to participate in much of the growth, appreciation and income potential provided by a vibrant equity market, while also actively managing against major pullbacks associated with macroeconomic shocks that we’ve been experiencing over the last few years. Achieving this – capturing most of the upside while limiting the downside – isn’t easy. It requires both deep company-specific analysis and a strong top-down, macroeconomic framework. And we believe it requires investing globally to take advantage of the best possible risk-adjusted return opportunities wherever they are. Limiting the downside likely requires giving up some upside in a rally – and in this environment especially – we think that’s probably a good tradeoff. It would be great to be able to limit the downside without sacrificing any upside. Unfortunately that’s not realistic – but we believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term.

Although markets are again focused on risks from Europe right now, sentiment will likely swing back to “risk on” again, and people will wonder what all the fuss was about. And then at some point it will swing back to “risk off.” Equity investing in this environment isn’t easy or for the faint of heart. With long-term risks of global inflation, sitting on the sideline isn’t an option for many people. We think the right approach is to focus on the right companies and to be willing to give up a little upside, while working hard to protect the downside. Call it the New Normal of equity investing: Three years and counting.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.

Copyright © PIMCO

Tags: Asset Classes, Attractive Returns, Balance Sheets, Confusions, Downside, Equity Investors, Erian, Financial Markets, Global Economy, Growth Markets, Inflection Points, Investment Approach, Investment Professionals, Low Interest Rates, Market Volatility, Portfolio Manager, Quality Companies, Sidelines, Stewards, Term Equity
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Sector Relative Strength – A Bullish Trend?

Friday, June 8th, 2012

Tags: Amp, Bounce, Bullish Trend, Dow Jones, Downside, Industrials, Investment Group, Materials Sector, Nbsp, No Doubt, Outlook, Outperformance, Price Of Oil, Relative Strength, Sectors, Shaded Red, Signs, Theorists, Twelve Months
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I Should Have?!? (Saut)

Monday, May 21st, 2012

“I Should Have?!”

by Jeffrey Saut, Chief Investment Strategist, Raymond James

May 21, 2012

“… A man has rigged up a turkey trap with a trail of corn leading into a big box with a hinged door. The man holds a long piece of twine connected to the door that he can use to pull the door shut once enough turkeys have wandered into the box. However, once he shuts the door, he can’t open it again without going back into the box, which would scare away any turkeys lurking on the outside. One day he had a dozen turkeys in his box. Then one walked out, leaving eleven. ‘I should have pulled the string when there were twelve inside,’ he thought, ‘but maybe if I wait, he will walk back in.’ While he was waiting for his twelfth turkey to return, two more turkeys walked out. ‘I should have been satisfied with the eleven,’ he thought. ‘If just one of them walks back, I will pull the string.’ While he was waiting, three more turkeys walked out. Eventually, he was left empty-handed. His problem was that he couldn’t give up the idea that some of the original turkeys would return … ”

… Why You Win or Lose, by Fred C. Kelly

“I should have sold when the S&P 500 broke below its rising trendline on April 9th at 1397” (see chart on page 3). “I really should have sold on May 11th when the S&P 500 (SPX/1295.22) traveled below its April 10th intraday reaction low of 1357.38.” So exclaimed one disgruntled portfolio manager last Friday since the SPX continued to surrender ground. Plainly, the “I should have” crowd surfaced again last week as the SPX knifed through my envisioned support zone of 1320 – 1340, causing one savvy seer to exclaim, “Markets always go further than most pundits believe, both on the upside and the downside.” Yet the recent downside dive from May 1st’s 1415 level into last Friday’s close of 1295.22 has caused many of my indicators to register readings not seen in a long time. For example, the McClellan Oscillator is now at oversold readings not seen since the recent April 10th trading bottom (see chart on page 3). Then there is the CBOE Equity Put/Call Ratio, which is flashing a “buy signal” that has proven profitable at every downside inflection point since 1994; or, as the astute folks at Bespoke write:

“Following today’s 0.44% decline (5/16/12) in the S&P 500, the 10-day Advance/Decline line for the S&P 500 has now dropped down to –1,930. This is an extreme oversold reading based on historical standards. For those unfamiliar with the indicator, the 10-Day A/D line is simply a rolling 10-day total of the daily net number (of similar readings) shows that equities have historically rebounded after hitting such extreme oversold levels. Over the next week, the S&P 500 averages a gain of 1.21% with positive returns two-thirds of the time. Over the next month, the S&P 500 averages a gain of 5.58% with positive returns 83% of the time. Going out three months, the S&P 500 averages a gain of 7.68%, and over the next six months the index averages a gain of 13.35%.”

Adding to the litany of downside inflection-point indicators is the AAII (American Association of Individual Investors) survey that recorded its lowest bullish reading (23.6% bulls) since August 2010. Moreover, my parade of short/intermediate-term indicators shows a composite reading that is at historic levels. To wit, there have only been only four other times when my indicators have combined to show such negative inclinations. More than seventy percent of the time, given such readings, the major market averages have been higher a week later, while 92% of the time they have been higher a month later. Accordingly, unless we are in “crash mode,” and I don’t believe that, it is time to ready your “buy list” and begin judiciously recommitting some of that cash to stocks; and, that is what I have been recommending. Indeed, over the past week I have been recommending recommitting some of the cash we suggested raising in February – April. One of the techniques we have used to accomplish this at similar inflection points was first proffered by our friends at Riverfront Investment Group back in 2009. As stated:

“First, identify the quantity of cash to be put to work – example: 20%. Second, break the trade into digestible chunks – example: break it into four parts, 5% each. Third, implement the first trade today – example: invest 5% into equities today. Fourth, set a date for implementing the second trade – example: two months from today invest the second 5%. Fifth, implement third and fourth segments if market pullbacks occur – example: invest the remaining 10% of the cash on market pullbacks. And six, after the date of the second trade occurs, return to step one with the remaining cash – example: two months from today, if the market never provides the opportunity to buy on a pullback, break the remaining 10% up into 3-4 parts and follow a strategy similar to the one utilized for investing the first 10%.”

I think Riverfront’s strategy is appropriate since the SPX is probing its next downside energy level. Further, the stock market’s internal energy level is totally exhausted on the downside, implying a tradable bottom is likely at hand unless we are involved in a mini-crash. The real question thus becomes, “If we get a rally from this oversold condition is it the start of a new “up leg,” or is it just a compression rally that will be brief followed by still lower prices?” Speaking to that point, it is worth considering the SPX is currently trading at a P/E ratio of 13.1x earnings. Since record keeping began there have only been five occasions when a bear market began with the SPX’s P/E ratio below 15x. Another timely question is, “Will the recent Dow Dive trigger QE3, Operation Twist II, or targeting GDP?” While equity markets can clearly do anything, at worst we should at least get a relief rally from here and at best it could be the start of a new “up leg.” Therefore, I think the gradual re-accumulation of investment positions is the correct strategy. For those participants not wanting to try and “catch a falling knife” by purchasing the exchange-traded product of your choice, a more conservative approach would be to accumulate dividend-paying stocks. Some that screen well technically, and have a Strong Buy rating from our fundamental analysts, for your potential shopping list include: 3.0%-yielding Automatic Data Processing (ADP/$51.98); 3.8%-yielding Rayonier (RYN/$42.08); 4.3%-yielding Digital Realty Trust (DLR/$68.48); 5.2%-yielding Enterprise Products Partners (EPD/$48.48); and 8.2%-yielding Linn Energy (LINE/$35.24).

Tags: Amp, Chief Investment Strategist, Corn, Crowd, Downside, Fred C Kelly, jeffrey saut, Last Friday, Mcclellan, Nbsp, Osc, Portfolio Manager, Pundits, Raymond James, Saut, Seer, Spx, Support Zone, Trendline, Turkeys, Twine
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Corporate Bond Chaos, ETF’s, and JPM’s “additional losses”

Friday, May 18th, 2012

by Peter Tchir, TF Market Advisors

Corporate bonds in the U.S. took a beating in the past 48 hours. The high yield market, which had been spared much of the carnage seen in the HY CDS markets, finally succumbed.

This chart is key for a couple of reasons. First it shows that the 3 point drop this week and the 2 point drop in the past two days for HYG is largely a catch up to moves that had already occurred in the CDS market. We still think of HYG as a “retail” product, but volumes have spiked in recent days as it has become a valued source of liquidity. Hedge Funds have been looking at the ETF versus the HY CDS index. A trade we have liked, that as recent as 4 months ago was generally met by polite grins from some of the HF’s we talk to. Now it is a strategy people like. More investors and market makers are looking at the ETF’s as a better way to hedge themselves than using the CDS index. The HY ETF’s have their own sets of problems, but there is a growing realization, particularly in the high yield market, that at least they move with their bonds more than the CDS indices.

We are starting to see spikes to the downside late in the day. It could be for any number of reasons, but the reality is that I think it is market makers more than anyone who are causing that. To the extent you get hit on bonds in the morning (you didn’t fade your bid fast enough, or the client was too important) you spent the whole day trying to move those bonds. With everything going on in Europe you don’t want (or aren’t allowed) to be long overnight. Your choices are hitting a down bid on the bonds – probably a loss of at least 1%, shorting HY18, which is already very cheap and the index guys get annoyed at anything less than $25 million, or, shorting some HYG. It might cost you a ¼ point, but that is better than selling the bond and it seems closer to the market than the CDS index which feels ripe for a squeeze. That flow is occurring.

The HY ETF’s are both trading at a discount. That is encouraging the arb which means arb clients will be selling bonds, buying shares, and then using share redemptions to monetize the trade. Again, it seems like a “market neutral” strategy, but for some reason, the selling of bonds seems to weigh more on the market than the purchase of the ETF’s. That adds to the downside pressure, and there is currently a big game going on of “which bond will the ETF’s sell”. That is adding to the volatility in the cash market.

I’m struggling to figure out what is affecting U.S. high yield so much. Hedge funds don’t seem too leveraged. Banks don’t have much inventory. Retail doesn’t seem spooked (the redemptions seem to have as much to do with arb activity as retail outflows). I think this is the opportunity we have been waiting for to increase our allocation in HY in our Fixed Income Allocation.

I have to say something about JPM here. The positions at some level were long assets in an available for sale account (which had over $7 billion of untapped profits on a portfolio of $200 billion, according to the transcript). From everything else I have pieced together they were short HY market via CDS and long IG via CDA – JPM details. You notice how HY CDS got tighter every day from the 21^st until the 30^th. That would likely have produced a loss in the whale trade. According to the WSJ, there was a meeting on the 30^th. Between then and the 10^th when the call occurred, HY moved in their direction every day. That move has accelerated. How much of this hedge did they keep? Did the funky nature of their hedge perform the same as the on the run index? There is no way to know what happened, but on the HY CDS leg, the market has done nothing but move in their direction since that first emergency meeting. Their cash positions in the AFS, which should be marked at the lower of cost and market value, had an average gain of 3.5%. That portfolio, using that form of accounting won’t have had a loss (it probably has less untapped gains, but no accounting loss). Again, impossible to know what happened there, but certainly food for thought.

Investment grade also was in real trouble yesterday, though the CDS market has been indicating that for days. LQD was down almost a point, and that is on a day where TLH was up over a point, amplifying the spread widening. While cash was that weak, IG18 only weakened into the close at it, somewhat surprisingly spent most of the day near unchanged. While the selling pressure in the cash market was real, and somewhat scary, the relative strength in CDS was encouraging as it has been the leading indicator in this entire sell-off that really started after the JPM announcement.

This graph shows the IG9 10 year index and the IG17 5yr since the start of the year. You can clearly see how fast the widening has been, which started in early May and accelerated after the JPM conference call. There are a couple of things worth thinking about here. For everyone just looking at the performance of IG9 10 year and “guessing” what the additional JPM loss is, it makes almost no sense. If it was that simple, JPM would have had huge gains on this trade in the first quarter. Even in April the change wasn’t much. If it was all the “basis” and the difference between the indices that caused the problem, you have the same issue, that it was fairly stable though out the year. It has widened, which is likely bad, but again, doesn’t really explain the P&L. If IG9 was actually tightening coming into April 30^th, why was JPM having losses? First, IG9 did seem to move slightly less than IG17 in those last few days of April. But if JPM was long the index, they should have some gains. The problem, I believe, and am trying to confirm, is the tranches didn’t move with the overall index. A quick look at MBIA, which would be a driver to the tranche price (the ones JPM had on, have a higher “delta” on the weakest names) supports that. MBIA CDS actually widened from April 17^th when it was 884, to 970 by April 30^th. Radian had an even larger move wider, which again would have hit pricing on “mezz” and “equity” IG tranches. Doing more work, but it will have been a widening in high beta names, driving the tranches they owned wider that would explain the loss. The underperformance of IG9 vs IG18 in that period is largely because of the high beta names, the ones JPM had the most exposure too. The big question here, is did they just go very short IG17 or IG18 against the tranches in that first part of May when it was freely for sale, still trading rich, and priced as low as 93 for IG18 which is currently at 120? Again, impossible to know, but the simplistic IG9 10 year explanation that is out there has no real basis in fact.

Maybe the G8 will threaten Germany with becoming the Growth 7 and she will cozy up and change her tough stance? It is scary that the ECB and Germany seem oblivious to the risk of a Grexit, and I’m frankly scared at some of the simple solutions the ECB seems to have for their losses – put them into the EFSF. But more people are coming out and pointing out the dangers, and Europe if anything, has demonstrated great fear of decision and kicking the can with a skill that even Messi envies.

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E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

Tags: 4 Months, Carnage, Chaos, Corporate Bond, Corporate Bonds, Downside, Extent, Hedge Funds, Hf, high yield, Hy, Hyg, Jpm, liquidity, Losses, Realization, Retail Product, Spikes, Squeeze, Tf
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Don’t Like the Real Data? Just Pretend!

Thursday, April 26th, 2012

Tags: Bulls, Clue, Conclusions, Confirmation Bias, Corporate Earnings, Credibility, Critical Thinking, Denial, Downside, Earnings Reports, Economic Collapse, Investment Decision, Jeff Miller, Observers, Profit Margins, Rebound, Recession, Recovery Period, Simple Solution, Workforce Reductions
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Volatility is Back! (Tchir)

Saturday, April 14th, 2012

by Peter Tchir, TF Market Advisors

Volatility is back. The S&P moved more than 1% on 4 of the 5 days, had the biggest down day of the year, and even the least volatile day was a 0.7% move.

Back on April 5th, we saw a warning sign in the credit markets that the bid/offer spread for European CDX indices was widening. This has extended into investment grade indices in the US where not every dealer maintains a ½ bp market anymore. That lack of liquidity, which has also been a factor in the sovereign debt market (especially for Spain) has hit the equity markets as well. We are seeing bigger moves on less information. I believe that this volatility will continue in the short term and that we will see at least one big capitulation to the downside in equities. The Nasdaq seems more susceptible to such a move since it is still trading above the 50 day moving average.

European stocks underperformed. That is likely to continue. The problems in Spain and Italy will be directed much more towards European institutions, and banks in particular this time around. Generically I like being long US financials versus short European financials, because although the entire market will get dragged down by renewed problems in the Eurozone, the correlation will not be as high as last time.

The Whale

It is hard to talk about trading last week, particularly in the credit markets, and avoid the big JPM CIO trading story. I think that as details come out, the size of the position has been blown out of proportion. It will be much smaller than some of the headline numbers, and there will be long and short components and it will make a lot of sense both from a specific trade standpoint and also from a JPM business risk standpoint. I continue to believe that it is more in IG9 tranches, with hedges in HY, also possibly in tranches, and some curve trades.

In any case, the trade is still large and should raise concerns for regulators. The too big to fail argument is one obvious question that needs to be addressed. Is this trade for the “bank” or for the “investment bank”? For those looking for a much clearer segregation of the businesses run by JPM, this trade will be something they can point to. It is coming to light in a period of relative calm for the market, unprecedented support for banks from the Fed, and general disdain of bankers from the public in an election year. That could be what is needed to ignite a push towards a return to Glass Steagall or some other new legislation.

It may also be the straw that breaks the camel’s back in terms of pushing derivatives on to exchanges. This is something that should have been done immediately after Bear Stearns if not before, but for a variety of reasons (bank lobbyists) has been avoided up until now. The regulators should examine the whole chain of these trades. Who bought them and what they did with them? How many billions are sitting in mark to model books as opposed to having been traded? How much smaller would the trades been, and how much less would any distortion be, if every trade was on an exchange with a standard initial margin requirement and variation margin?

Regulators need to examine the whole series of trades, not just what JPM has on their books, and a renewed effort to develop proper exchange traded CDS needs to be done. None of the arguments against this have much credibility, as mark to model carries risk, and if the market has to shrink to support proper margin requirement, who really is hurt?

Jobs and Housing

The jobless claims this week were bad, plain and simple. I have seen arguments that more people quit, so it is “good” jobless claims, but since I have never seen a report detailing how many people were laid off but not eligible to make claims (which I think is a growing proportion of the workforce), I will largely ignore that positive spin.

Virtually every data point signals that the January and February reports overstated the real long term improvement in the economy. The jobs number is important, but mostly for what it could have meant to housing. Ultimately, we need the housing market to rebound to see the economy as a whole benefit, and that data lagged the job data all year long. The hopes were that somehow the jobs data was correct and housing would catch up. Now, it seems clear that housing was correct and jobs were overstated, so we may have a lot longer to wait for that housing recovery.

Without a housing recovery the market will struggle to go up much from here. It is too important of a sector, so it is hard to be bullish at these valuations with no real support from housing.

China and Europe

China disappointed this week. There is no landing yet so it is impossible to determine whether it will be “hard” or “soft”. I am leaning more and more towards hard, as I find it hard to believe the weak data reflects the whole truth, and there seems to be enough real concern about inflation in China and the state of the banks that more easing may be slow to come, and the pressure on the banks and property may come far faster than any new easing policy can stop.

Spain is in trouble. There is no liquidity for their bonds. Spanish 5 year and 2 year bonds now trade with higher yields than Italy. That was always the case in CDS, but the LTRO money and much smaller Spanish bond market had distorted that relationship in the cash markets. It is an ominous sign that those spreads have moved so much – as it shows that not only is LTRO no longer working for sovereign debt, but that the banks own too much and are better sellers if anything. The focus is on the 10 year, and the fact that it looks set to breach 6%, and that is bad, but this rapid normalization of the shorter end of the curve is possibly even more important.

Any fund that purchased these bonds leading up to LTRO2 is now facing a significant loss, and the lack of liquidity is scary. I do NOT think the ECB will step up in a meaningful way this week. The EFSF is supposed to take over secondary market purchases, and it is shameful that it doesn’t seem set up to do that yet, but there are other reasons that the ECB may not buy bonds. It is close to what it viewed as its limit for SMP, which leads to the obvious question of why didn’t they sell some bonds in the past month when the markets were hot? More importantly, the countries may not want the ECB to buy bonds if they are seriously considering a PSI. The ECB holdings were incredibly disruptive during the Greek debt negotiations and are the primary reason the restructuring has been a failure (any restructuring where the new bonds trade at 20% of par has to be deemed a failure). So don’t get too excited about possible ECB intervention.

There is some talk about Eurobonds (again) and various other possible programs to unite Europe, but I don’t see that happening any time soon. I think the strangest thing is that Spain agreed to 3% deficit target in the future. I never believed it would happen, but healthcare costs aren’t part of the Spanish deficit. No, in Spain, healthcare is largely a “regional” issue. That is why the regions are in such deep trouble. It is clear that no country in Europe counts for anything in the same way, and any of these “targets” is easily manipulated with some simple changes, and the use of “guarantees” as opposed to debt.

The Spanish debt load is looking like a “black hole”. You start with what seems a manageable sovereign debt to GDP ratio, but finally gravity is starting to pull regional guarantees, bank debt guarantees, off market swaps, and banks full of unrealized property losses, into the same spot. That “black hole” is not manageable and as realization hits, Spain can choose to struggle for years and capitulate down the road when things are much worse (like Greece did and Portugal is in the process of doing) or they can stop the nonsense and work out a proper debt restructuring plan now. This will hit European banks harder than any other sector.

The Outlook

I expect lower equity prices at some point this week. We may open with a bounce based on some IMF announcement or some ECB intervention, but this is why I think one more downleg:

• Spain in particular, and Italy to a less degree will weigh on the markets, dragging European bank shares down, and affecting the rest of the market
• Realization that the data in the US has been decidedly weak over the past month will finally overwhelm the market and those clinging to memories of January and February NFP
• QE in any of its myriad of forms is further away than the market currently priced in, the reaction to Yellen’s comments shows just how critical QE is to stock market valuation, but it is NOT critical to the economy and those concerned that it is actually hindering the economy are becoming more vocal, so QE expectations will take another hit
• Credit markets are becoming more volatile, less liquid, and not just in CDS and for banks, but across the board, this has been a consistent leading indicator of further weakness
• Weak data globally, and not just in the U.S. has been ignored so that will come into play making any sell-off that much worse
• AAPL. I have no real reason to dislike AAPL, but lots of “fast money” seems to be sitting on big profits and could choose to sell, and the price seems to have outrun what is actually being accomplished, it seems like it is being valued on I-Phone 7 sales, I-Pad 5 sales, and other future earnings while ignoring that everywhere I go, nothing is sold out or difficult to get – like it used to be. For this reason, I like Nasdaq to underperform. Also, if big companies start spending billions of their cash hoard in what might be viewed as a frivolous manner, then valuations for the entire sector can drop quickly.

As always we will see what the data comes up with, or whether any believable political, central bank, or supranational institution actions develop to change the view. I don’t expect anything dramatic, but could certainly see the S&P 500 pulling back towards its 100 DMA, now that is has breached the 50.

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