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Black Wednesday


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I did watch them and then I googled articles about him. Hedge fund manager warning people that cash might be the least safe option.

Where shall I put my cash? Hmm, how about a nice big hedge fund?

This is really unfair, he is saying much more than that.

You're just showing off because you've got a black week thread.

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He's not really suggesting anything but he doesn't beat around the bush.

:(

It's quite easy what you need to invest in is trade-able items, tins of food, toilet paper etc..., invest in skills such as plumbing etc...

If nothing is safe it's going to be a barter economy, in the modern context gold isn't going to cut it.

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Back to half a percent down now. HPC contra indicator set to stun?

Its a drip drip drip crash but it will still lead to a flood eventually, no other solution but to let it virtually fail than start again on honest fundamentals and honest balance sheets.

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That's an interesting hypothesis. Sterling has taken a pounding against the euro since January this year when exchange rate hit 1.2+. I'm hoping it'll head back to this level soon as I want to move ££ across. What are your thoughts on this?

It's certainly interesting, however, I think the strength of the euro has more to do with the ECB raising interest rates than anything else. I wouldn't move sterling into Euros at current exchange rates - hold your fire :-)

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It's more frustrating for me - much of[1] my wealth is in equities already.

[1] approx 65 per cent of my unearned income is divis.

That was one remark I liked from Ari Bergmann : 'you are forced to take risk when they are highest', or something to that effect.

Here is a blog you might want to follow if you don't already know it (h/t ZH ... as usual):

http://capitalcontext.com/2011/06/15/now-then-when-and-ben/

Today saw yet another day when the much-expected dip-buyers failed to appear as equities underperformed credit even as both markets dropped significantly. As a measure of the relative selling pressure in equities today, the chart above shows that we saw a very notable underperformance relative to our risk basket expectations.

Further macro disappointment combined with the anticipated approach of an endgame in Europe, the disappointing post release performance of Pandora’s IPO combined with high beta selling and Energy and Materials weakness was further sign of concern.

We can’t help but feel some schadenfreude as we note financials (equities and credit) continuing to slide and we hope the advice over the past month has proved profitable. Rather than be greedy, we strongly suggest taking some profits – at least half for now – off on our very profitable HYG-LQD decompression trade (almost 10% since mid-May inception) which is closing just shy of our target of $44.

We have been and remain bearish – even with the growing cacophany of ‘wall of worriers’, ‘buy the dippers’, ‘pause that refreshers’, and ‘transitory weaknessers’. The simplest perspective on why we see further downside potential is explained more fundamentally and technically below but in the short-term, we gain confidence from the flatness of vol skews, the still richness of stocks relative to credit, the very weak breadth in secondary bonds, and lack of support from financials.

20110615_Skew-300x214.gifEquity market vol skews remain only at average for the year - investors are not protected enough for a meaningful bounce yet.

In talking with clients and readers alike, we get the sense that there is not enough fear that this will end badly. Simply put we have become cognitively biased to expect ‘someone’ to buy-the-dip. It has not happened this time (yet) and unfortunately the market is also not well protected and has become ill-prepared. We discussed credit option vols before as being very tight relative to realized vol and the cycle we tend to see in volatility (implieds and realized) following ‘events’. This has played out once again as the last two moths or so has seen skews flatten notably (and the term structure) – which for now seem very prescient as contrary indicators since every man and his small labrador now seems to be an expert on VIX (short-term near the money vol).

The chart above shows that investors are starting to get ‘protected’ again in terms of large drops – something we said could not happen until we saw a notable drop in skews since the forced selling into weakness was unlikely unless crash risk was less richly priced. We are only back to the average skew levels for the year – which could signify some slowdown in the selling – and the fact that we are close to the 200DMA and the Japan quake support lows will likely spur a small rally – but for now we see consaiderably more downside risk to equities, expect HY vol to rise notably more than equity vol, and see the up-in-quality trade playing out everywhere.

In secondary bonds – short-maturity selling (very overcrowded reach-for-yield trade) as TSY front-end saw buying on rumors of caps/language changes, low volumes in HY and net selling overall, net selling in financials, and the start of basis compression in bank CDS-Cash basis are all concerning.

We have discussed the situation in Europe extensively. We gave context on the GGB CDS-Cash basis, who was really buying, what was happening in Spain, contagion problems, and most importantly – we were critically aware that this was a solvency issue and not a liquidity issue – which seems to have suddenly hit everyone by surprise. Let’s be clear, this was easy to see coming; any firm that claims major losses from this event should be questioned vociferously on why hedges werent applied. Today’s Fed-speak included a comment that the Fed was there to counter over-optimism – aside from that being a joke given QE2′s specificied goal, the European regulators shoudl be crucially aware of the same contagion issues we have been indicating for months.

20110615_EUR-risk-300x214.gifSince Mid-April, GDP-weighted European sovereign risk has risen dramatically while EURUSD has only just budged - more to come.

A great recent paper (Credit Spread Interdependencies of European States and Banks During the Financial Crisis) indicates this with more academic aplomb than we do but the chart above should help in comprehending the changes that are possible should this proceed to the kind of endgame we suspect will occur. The chart shows a GDP-weighted measure of European Sovereign risk – much more broad and applicable than the more liquid traded index SovX. We compare it to the EURUSD rate. Unlike, SovX which spikes around, our measure is much more codependent / correlated with EUR over time. Note the drop in the sovereign risk in late 2009 as risk was transferred from public to private balance sheets initially did not ‘help’ the EUR.

Our key takeaway is that post QE2, the sovereign risk and exchange rate has synced well – up vs up and down vs down – having a very high Kendall’s Tau measure of relative performance. Since mid-April, risk has risen very notably and while EUR has drifted a little lower – it is clear that there is a very notable divergence. Its clear that the volatility in EURUSD has risen dramatically since Mid-April and we suspect further EUR weakness is much more likely here. Add to this concern that this weekend is supposed to have some resolution (June 20th) to the Greek payout and it coincides with the roll of the CDS contracts and we may see some turmoil the rest of the week in credit (and one more thing to stir the pot is that it is OPEX in equity land too this week).

Having quickly looked at today’s action and the current context, we wanted to lay out some general thoughts on what has happened in a credit-equity context over the last year or two and where we see it going (more specifically with the goal of understanding what could drive us up or down overall). These notes were written for an appearance on CNBC, so forgive their less-than-flowing prose, but they highlight what we see as important in a digestible manner.

While we are bearish, there are bright spots in that we strongly believe investors rotating into IG credit (ex insurers and financials) will save themselves a lot of pain in the medium-term, avoid HY and equities for now (HY even more so than equities), and read the tea-leaves of the credit market for insight into the underlying dynamics of the market. There are always opportunities for outperformance in stocks, whether sector rotation or stock selection but broadly getting directional views correct makes up the bulk of absolute performance and credit is sounding the alarm bells loud and clear (just like it did before!!).

Credit anticipates and equity confirms is a phrase that many in the markets often use. This has been the case here and portends further weakness in equity and credit markets to come.

A quick flow of the discussion below is as follows - brief explainer of what drove credit strength last two years, where we got to at the peak (trough in spreads), where we are now, what drove us back to year’s wides in credit, and what we believe this means for equity and credit markets going forward.

The current theme is up-in-quality and up-in-capital-structure as the balance sheet recession pokes it ugly head up again and the necessary monetary and fiscal policy remedies proposed in textbooks to fix this ongoing deleveraging and balance sheet repair seems politically most unpalatable.

The last two years have been characterized by a fundamental hope that recovery is sustainable (on the back of large government-funded fiscal and monetary policy actions), that housing will rebound (and hence bank balance sheets will slowly but surely repair themselves), and a virtuous cycle in the corporate bond market.

20110525_Virtuous-Circle-300x243.pngAs with all self-reinforcing systems, we suspect the velocity of the unwinds we will see in the corporate credit market could pick up. This latter point is critical (we think it is really important to understand the dynamics) – the cycle of demand for new issuance (whether due to low interest rates driving demand for yield into more and more levered firms or by a generation of investors rotating away from stocks and into bonds as they retire) combined with the aggressive demand from hedge funds, dealers, and asset managers who have seen healthy profits from basis trading (buying new issues and flipping them for a quick profit, buying new issues that are cheap and buying protection against them) has been feeding on itself.

This demand reduces refinancing risk for companies which lowers default risk in the short-term which lowers credit spreads in the short-term and steepens credit curves – all of which reduce spread and therefore yield and drive demand for more levered investments up further. This also enabled firms to lower interest expense significantly and reduce costs and therefore improve earnings (which they also achieved by reducing employment costs and increasing productivity).

The point is this somewhat archaic but hugely crowded trade is self-fulfilling as we described and thanks to the momentum that we have gathered since the MAR09 lows, hedge funds, insurance companies, and dealers have become very heavy in corporate credit (and more over levered firm credit risk and levered instruments such as CMBX and ABX).

This leads us to where we are now. In mid Feb we started to see cracks appearing in HY spread markets and financials beginning to underperform in credit markets. The Japanese quake in March also stumbled it further as fear sought safety in investment grade bonds and not high yield. Many of us started to see an exuberance in credit markets that was very reflective of the Great Moderation period as spreads fell dramatically (and in HY, yields fell to record lows thanks to record low interest rates also). Loan covenants and PIK bonds reappeared, extremely long-dated credit was issued, credit risk premia were very low (even for highly levered firms), credit curves became extremely steep (signaling a view of very low default risk in the short-term), and demand for new issuance met the huge supply head on no matter what the credit was.

It certainly seems clear that credit market participants had begun to anticipate the macro weakness as QE2′s crowded investors out of the TSY market and into more risky assets like US equities. Relative to credit market cycles, US equities are 20-30% over-priced here (yes that seems large) and the bulk of that richness has come since Jackson Hole as credit markets initially benefitted but quickly stabilized and flattened.

There is lots of critical nuance in the credit markets and that is why keeping the credit, equity, and vol markets in context is important for all investors – watching equities alone can and will lead to missed opportunities or worse losses instead of profits.

The credit markets started to send signals of a slowdown in mid Q1 as HY spreads underperformed (telling us that investors risk appetite was waning), financials (the leaders) saw credit spreads deteriorating (on contagion from European sovereign risk as well as a recognition of the huge wall of debt they need to refinance – TLGP paper due in Q4 this year alone is $50bn plus and will raise interest expense dramatically), and credit underperformed an exuberant stock market day after day. All of this was happening as stocks rose day after day and so was quite telling.

Then about two months ago we saw a notably weak change further – The CMBX and ABX markets started to retreat, we specifically noted the movement in their prices appeared to signal professionals positioning for a rise in systemic risk in the real-estate markets, new issues started to underperform (leaving dealers and funds with underwater positions that they have not had to deal with in a year or two), macro hedges were applied (as investors bought protection in credit and equity markets – while VIX was low, the more scary crash protection or skew was well bid), HY spreads rose significantly, credit term structures began to flatten, and the equity market began to correct in the context of credit.

The last few weeks have seen credit shouting alarm bells. The 30 highest systemic risk financials are almost double the risk of their post crisis lows and are trading at almost one year wides, obviously sovereign risk in Europe is at extremes (and no matter what happens it is very likely an event in CDS will be triggered – something we discussed in the fall by the way), internals in HY have become dreadful as the advance-decline line on issues has dropped significantly and liquidity has dried up (too many sellers and not enough buyers), and the Fed’s approach to the Maiden Lane unwinds has seemingly been the Tipping Point for many market particpants as they are unable or unwilling to soak up the supply (and hedging of existing positions has leaked from CMBX/ABX (illiquid) to HY and LCDX (liquid)) – whether on concern (inability/timeliness of analysis of the pools) of quality, inability to hedge, or simply bloated.

There are other more complex signs of trouble (index skews, curve steepness, correlation shifts) but the bottom line is that there is a large crowd of increasingly anxious long credit positions stuffed into the majority of buy- and sell-side firm’s portfolios and it seems that we have reached a tipping point in terms of their ability to soak it up at the margin.

We strongly believe that following the trend of up-in-quality (a preference for IG credit over HY credit) or even TSYs has (and will continue to) prove a prudent position as will up-in-capital structure (a shift to bank loans and away from equity). Buying high dividend stocks and arguing they ‘yield’ more than bonds makes no sense in an environment where capital is at risk and preservation of capital seems most critical as we suspect the large crowded longs of more levered credit market participants try and pass through a smaller and smaller door in the coming months.

Yeah buts or What-Ifs-> Government passes new spending bill or cuts taxes (will help in short-term but will be sold into by professionals as we have seen recently on any pop higher as view is that slower global growth will exaggerate a hole far bigger than even a reserve currency holder can fill without drastic implications); Earnings and profits beat (they are beating analyst expectations at the cost end of the spectrum and if credit starts to flag then they will have to improve on their own – not via accounting help); Cash on balance sheets (Japan did the same and then burnt through this pile as healthy growth never returned – furthermore they used this to reduce debt and not to juice returns as the balance sheet recession continued – this is what we will see here); repatriation of foreign cash (same happened in Japan and a lack of domestic opportunities for growth will mean further hoarding of cash with no multiplier effect for stockholders); Transitory slump (expectations of a second half recovery in global growth seem predicated on the mean-reversion of every Keynesian macro view – while we do not expect an end-of-the-world type event – though wouldn’t be surprised – slower than expected growth and peak margins will not help encourage above trend growth anytime soon).

Bottom Line

The credit market is critical to further growth in the domestic and overseas markets as it enables firms to avoid delevering and the deflation that will cause – if we see credit continue to weaken as we believe it will (despite fund inflows) then we could be set for further cyclical deterioration. Credit markets are bloated with inventory and the marginal trade seems more driven by traders looking to unload into strength than ride any more momentum – this is the first such shift since the crisis and can quickly become self-fulfilling on the way down as fund flows withdraw from riskier assets (HY for example) and force selling at inopportune times (and note that most funds have very low cash levels to soak up any outflows as they have been trying like crazy to keep pace with a market forced higher by the Fed’s QE2 crowding out).

There will be opportunistic times to re-enter the broad equity market (and of course we believe that performance can be greatly enhanced by careful stock selection and understanding context) but for now we are flat stocks (and have been since mid April based on our investment frameworks).

Side-note – deflation or disinflation is often seen as a positive for bonds overall BUT at current low levels of interest rates AND relatively large spreads, deflation is very negative for HY credit since they are so much more levered that their balance sheet weakness significantly – liabilities remain fixed as their assets deflate in value – pushing them closer to bankruptcy…the side-effect (or lagged effect) of a jump in so-called inflation (really meaning the price of things we need) is a deflationary impact to the economy as discretionary spending is reduced on a fixed income as required spending eats into it.

The chartbook below contains a variety of current and historical data which linked with our recent posts (Financials, Bond Breadth Bad, Systemic Risk Rising, What We Are Looking At, and Bearish Bias) highlights our recent prescience and the performance of our beta-protected TAA + A-List program should confirm the relevance and need for contextual understanding in today’s investable markets.

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I am basking in my glory and beeing fanned by a bevy of scantily-clad women who now flock to my side for my wisdom and deep insight.

TMT in 'I ain't going to let you lot forget this' mode.

Dire retail sales figures, Greece imploding. FTSE back to where it was in Mar 2010. Must be a buying op.

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I am basking in my glory and beeing fanned by a bevy of scantily-clad women who now flock to my side for my wisdom and deep insight.

TMT in 'I ain't going to let you lot forget this' mode.

:lol:

Why don't you bring your thread back up? This one is a corpse.

Edited by _w_
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Dire retail sales figures, Greece imploding. FTSE back to where it was in Mar 2010. Must be a buying op.

This is the thing that keeps nagging at me. People are more afraid of selling than buying until they get a 2008. You would have thought three years after 50% crash people would be more fearful.

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This is the thing that keeps nagging at me. People are more afraid of selling than buying until they get a 2008. You would have thought three years after 50% crash people would be more fearful.

It's the opposite.

In 2008 the equity markets waterfalled whilst already in a bear market. That's not the condition we have today, though it may develop into that over 6 months or so.

I still think this will be a near term buying opp. but we'll find out over the next couple of weeks.

http://tradersnarrative.wordpress.com/2011/06/10/sentiment-overview-week-of-june-10th-2011/

aaii-4wk-moving-avg-jun-2011.png?w=623&h=361

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"“It is difficult to continually kick the can down the road when the can is breaking up in front of your boot,” Jim Reid, a strategist at Deutsche Bank AG, wrote in an e-mail today. “That is how the Greek situation appears at the moment. The most likely scenario is still a market-friendly outcome, but the risks are building as the situation gets ever more difficult to see the endgame.”"

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I still think this will be a near term buying opp. but we'll find out over the next couple of weeks.

It's my feeling too. One more reason why I'm worried. :)

We seem to be following the rules of a parallel universe.

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