Goldman Dissects The Equity Market Sell Off

From Goldman's Noah Weisberger, responsible for such pearls as Goldman's Top Trades for 2010

• Macro themes have become prominent in equity space again.
• Half of the May sell-off in the SPX can be traced back to a downward shift in growth views, with the other half due to unexplained or “risk-off” factors
• This is consistent with some components slowing under the hood of our Global Leading Indicator.
• Low interest rates should continue to underpin pro-cyclical assets, and a renewed broadening of growth would also help.
• The market correction has helped close the valuation gap between energy stocks and commodities.

1. Overview

Following another challenging week for risk assets, the US equity market closed up on Friday, with European markets mixed. Asian markets were mostly down to end the week, save for China, where A-shares rose more than 1%.  Although LIBOR/OIS continued to widen, the Euro strengthened a bit at the end of last week and key cyclical FX crosses stabilized after some bruising moves earlier.

Asian equity markets have so far spent the session in the green, with the stellar outperformers the Chinese equity market.  A-shares are up close to 3.5% as we write.  The performance today has been helped by the 5% rally in the property sector. Continued media commentary that the Chinese authorities are not going to roll out any further measures to cool the Chinese property market and will rather pause to see the effect of the measures introduced so far has helped the performance.  Copper has mirrored the performance of Chinese equities and is up so far today.

Asian FX has put in a better performance after the positioning washouts at the end of last week.   INR, IDR and TWD are slightly stronger than the Friday close. By contrast, major FX has had a relatively quiet overnight session.

Spurred in part by favorable Fed commentary (and a moderation in their inflation forecast, despite stronger economic growth) as well as a softer-than-expected April CPI report, the US 10-year yield briefly flirted with 3.10% intraday Friday before returning towards 3.25%.  With a continued bid for “quality” assets also supportive for fixed income along side the macro data, we decided to take potential gains on two rates trades: our 2s-10s flattener in USTs and our long US 10-year Treasuries vs. short Bunds recommendation. We have recommended positioning for a rise in UK 5-yr real rates, through inflation and nominal swap rates.

2. Squinting into the data glare shows some narrowing

Despite a better Friday, European sovereign risk and US financial reform continue to weigh on markets, causing some to connect the dots from these sorts of concerns to broader questions about the health and sustainability of the global cycle. Our baseline view remains that these fears are overdone. Indeed, in Wednesday’s Global Economics Weekly, Jim O’Neill argued that the world remains “Better than you think” with the needed austerity in peripheral Europe posing only minimal challenges to our above consensus global real GDP growth view. Importantly, conclusive economic evidence of a shift in the business cycle has yet to materialize.

However, there are some faint signs of fraying around the edges of the evolving macro data set, and, especially in the US, we continue to expect a second half slowdown. US retail spending continued to grow in April, but the acceleration in spending has paused. Weekly UI claims have stalled, and shown no improvement for several months. The Philly Fed survey inched up by a tenth of a point in May, but key leading subcomponents (New Orders less Inventories in particular) failed to make headway, as has been the case for several months. Euroland PMI fell in May, though it remains solidly in expansionary territory, indicating a slowdown in the rate of growth but not a shift in direction, as did German PMI after a blowout reading in April.

Our all in measure of the global industrial cycle, the headline GLI (a 12-mth change), climbed in May, as did the momentum reading (a 3-mth change), at least according to preliminary estimates. But the support base has narrowed, with moderate strength in some survey-based indicators offsetting a shift lower in more market driven bits of the index (trade weighted dollar and copper prices for example). Moreover, as we have detailed recently, the statistical guts of the GLI -- particularly how data trends are imputed - may be enhancing the current momentum readings, with the un-adjusted data showing less ongoing acceleration.

A simple diffusion index of monthly changes across an  wide set of 34 economic indicators, a measure we first introduced in late 2008 (to track the then-emerging “second derivative” shift in the data), is running a bit above the 50% range (i.e. more than 50% of the indicators showed monthly improvements). This is a far cry from the near unanimity seen in the data in early 2009, when the reading climbed to nearly 90%, but it is about average at this point in the business cycle. However, the diffusion index has been inching down of late and warrants continued monitoring.

3. Macro themes an equity market focus…

While data strength is certainly not as uniform as it has been in the recent past, May market damage has cut deeply. The SPX is down 12% over the last month and implied equity volatility (the VIX) is halfway back to 2008 peaks.  Any shift in the data is still nascent and miniscule at best, while markets have priced in more significant economic weakness than is yet evident. As Kamakshya Trivedi and Fiona Lake discussed in last Thursday’s daily, markets have not been sweet on China growth for some time. And, in May, the US bond market rally and the more recent collapses in the AUD and copper prices all go hand in hand with economically driven jitters.

Within the US equity market, macro themes are once again quite prominent. And not surprisingly, we have also seen our macro themed long/short equity baskets sell off. Our Wavefront GDP Growth basket is down 7% in the past month, Wavefront Consumer Growth – once a nearly unimpeachable market trend – is down a touch more, and Wavefront Housing Growth is down about 3.5%.  Our European Wavefront Growth basket is down similarly, though the UK Growth basket has held up quite well.

Indeed, as earning season has faded, macro focus has returned to the market rather rapidly over the last month.  Over the last month, nearly 75% of the observed dispersion in industry returns has been driven by differential macro leverages across these industries. This has been reflected in a shift higher in our macro trading index, which now sits close to all time highs.

Similarly, we have seen a marked pick up in correlations at both the stock and sector level. Interestingly, sector correlation has actually lagged a bit. So that controlling for a broad shift higher in correlation evident at the single stock level, there has actually been more scope for sector stories, even in a higher correlation world. We view this as a very typically indication that macro themes may be prominent at the sector level too.

4.…but index pullback outpaces macro shifts

Though macro themes are on the move again, it is worth mentioning that the macro shifts currently are not yet quite as pronounced as they were during the January / February sell off, and the index move this time around is more the focus. As we have done in the past, we use some of our macro-driven equity baskets – Wavefront GDP Growth, Wavefront Oil Prices and Wavefront Interest Rates -- as equity market “risk factors” – and then ask if top line market returns line up with tangible shifts in macro risk. We augment this set of risk factors with the GS Financial Conditions Index (ex-the SPX itself) too as an all in proxy measure for the economic growth impulse being delivered by financial easing in other asset markets.

Historically, as would be expected, we find that easier Financial Conditions, lower oil price views, lower interest rate views, and higher economic growth views are all positive drivers of SPX returns. These risks tend do a decent job of explaining market returns. Over time, macro risks explain about 60% of the monthly moves in the SPX.

Using this methodology, we find that the May sell off was half about “un-modeled” risk factors and half about shifting in macro driven themes. Specifically, of the 12% SPX from the late April peak thru the close on Thursday, we attribute a bit more than 6 percentage points to a shift in the macro risk factors discussed above. And the remaining 6 percentage points or so is pure risk “off” according to these metrics.

A downshift in growth views accounts for nearly all the macro driven decline, though the tightening of financial conditions FCI (as Dollar strength and credit tightness dominated falling yields) contributed a bit too. Falling oil prices (in the equity market’s estimation) was a small offset, boosting the index by about 30bp. Note, nothing here is a forecast or forward looking, rather this is simply a way of decomposing market returns into (macro-driven) risk factor loadings.

In levels terms, and base-ing off of where the index was a month ago, this simple decomposition puts the SPX at about 1140 currently. The current dislocation between macro-driven levels and the current market levels is nearly two standard deviations wide. This is a threshold that we have not breached since the late 2008 risk-market sell off, and the current dislocation is still modest by those distended standards. Interestingly, not only does this decomposition suggest the market has currently overshot macro risks to the downside, looking back at the end of April, this methodology also suggests the market overshot a bit on the upside as well, with a macro driven SPX peak of about 1200, as compared to the 1217 peak we realized. To be sure, the gap between macro driven index returns and the additional risk off features of the current sell off can "correct" from either side of the equation going forward, either from some market stability, or a sharper turn down in macro themes.

5. Risk off closes “energy divergence” gap too

One other visible equity market effect of the extent of the risk off nature (as opposed to macro driven nature) of the current sell-off, has been the behavior of energy equities. Over the last month, the US energy equities have declined 16%, underperforming the market by “only” 4%. This modestrelative underperformance stands in stark contrast to energy itself. Oil prices have declined sharply all along the curve with the two-year oil swap (which prices off the average of the first 24 months of the strip) down about 17%. So, relative to the even more dramatic pullback in oil prices themselves, energy equities, though down about in line with the equity market overall, have not been doubly punished for their energy exposure as well.

We have tracked this cross-market relationship for some time, and by late April we had noticed that (relative to the SPX), energy equities were about 2 standard deviations cheap relative to the underlying commodity (see “Tradewinds: Are oil equities rich or inexpensive?”, 4/13/2010). The  May sell off, with the commodity underperforming the equity, has dramatically narrowed – indeed all but closed (and in very short order too!) -- this gap.

This three part “oil convergence” apparatus -long energy equities relative to the broader equity market and short commodities - is a triad that also performed well during the 2008 credit crisis. The quality of energy balance sheets prevented those equities from underperforming the overall equity markets as oil prices declined. Though much more modest, we think that current concerns have led to a similar dynamic. And, although our metrics suggest these two markets have, more or less re-equilibrated, we could easily envisage the outperformance of the equity leg continue to run, should liquidity and risk concerns continue to be a  focus.

6. Current Trading View

The following trading ideas from the Global Markets Group reflect shorter-term views, which may differ from the longer-term "structural" positions included in our "Top Trades" list further below.

In FX:

1. Close short USD/TWD, opened at 31.74 on 31 Mar 2010, with a target of 31.0, and a stop on a close above 32.10, for a potential loss of 1.2%.
2. Stay long TRY/BRL, opened at 1.18 on 14 Apr 2010, with a target of 1.26, and a stop on a close below 1.14, now at 1.1847.
3. Stay short USD/MXN, opened at 12.8861 on 07 May 2010, with a target of 12.20, and a stop on a close above 13.20, now at 12.9691.

On rates:

1. Stay short 5yr credit protection in Mexico vs. long 5yr credit protection in Colombia, opened at a spread of -3bp on 16 Nov 2009, with a target of -150 bp, and a stop of 75 bp, now at -35.88 bp.
2. Stay short 5yr credit protection in Hungary, opened at 230 bp on 10 May 2010, with a target of 120bps and a stop of 290 bp, now at 263.73 bp.
3. Position for 2s5s flatteners in Indian swaps, opened at 119 bp on 22 Mar 2010, with a target of 70 bp, and a stop on a close above 135 bp, now at 99.00 bp.
4. Close 2s-10s flatteners in USTs, opened at 272 bp on 24 Mar 2010, with a target of 240, and a stop above 285 bp, for a potential profit of 20bp (inclusive of the negative carry).
5. Stay short 5-yr JPY swaps vs. a combination of 2s and 10s, opened at -41 bp on 24 Mar 2010, with a target of -20 bp, and a stop on a close below -50 bp, now at -45.72 bp.
6. Close long 10-yr US Treasuries vs. 10-yr Bunds, opened at 75 bp on 26 Apr 2010, with a target of 40-50 bp, and a stop on a close above 85 bp, for a potential profit of around 25bp (excluding carry).
7. Go short 5-yr UK real rates through swaps, opened at -78bp on 21 May 2010, with an initial target of -25bp, and a stop on a close below -95bp, now at -73.65.

Equity Trading Strategies:

Stay long German equities (DAX), opened at 5937.16 on 11 May 2010, with a target of 6550, and a stop 5650, now at 5829.25.

7. Recommended Top Trades for 2010 (opened on 02 Dec 2009 unless otherwise stated)

1. Stay short S&P 500 Dec10/Dec11 Forward Starting Variance Swap, opened at 28.20, with a target of 21, now at 35.4195.
2. Stay long Russian Equities (RDXUSD), opened at 1645.9 for a target of 2050, now at 1449.00.
3. Stay long GBP/NZD, opened at 2.29, with a target of 2.60, now at 2.1413.
4. Close short 2yr GBP swap rates vs. long 2yr AUD swap rates on a 1yr forward basis, opened at -268.5 bp, for a potential loss of 24 bp (inclusive of carry).
5. Stay short 2yr TRY rates through cross-currency swaps, opened at 8.77%, with a target of 12.0%, now at 8.49%.
6. Close long 5yr credit protection in Spain vs. short 5yr credit protection in Ireland at 13 bp, opened at 70 bp, with a target of 20 bp, for a potential profit of 2.9% (inclusive of carry).
7. Stay long the GS FX Growth Current, opened at 103.5, with a target of 111.8, now at 106.2905.
8. Stay long PLN/JPY, opened at 32.1, with a target of 37.5, now at 27.6727.
9. Stay long Chinese Equities (HSCEI), opened at 12616.01 on 01 Apr 2010, with a target of 15000, now at 11285.23.

Comments

[Noah Vail]

If this is supposed to be humor, its pretty damn tedious.

[ElvisDog]

I'll save everyone the trouble of reading this article. Whatever opinions Goldman Sachs releases to the public, the truth is exactly the opposite. Just swap every verb in this article with the opposing one, and you'll have a reasonable estimate of what they really think.

[roadlust]

And if they really thought the selloff was "overdone," where was their last second buyfest today???  (At such "bargain" levels!) 

Or maybe today was the headfake for them buying it up 2 percent tomorrow...  Remember, they make money trading "every day of the quarter." 

You can't win trying to play with GS "wisdom." 

Maybe they're shorting their own stock now.

[Bolweevil]

People pay him for that?

[SilverIsKing]

Hold all of that up to a mirror and you can clearly see GS' positions.

[naiverealist]

Gotta say that some of those top trades for 2010 look pretty shaky.  (Where did we hear "stay the course" to our detriment before?)

[Coldcall]

Long DAX? Sort of like EUR/USD will go mid 1.30s according to Jim.

[jkruffin]

Do as Goldman does, not as they say.  Has worked for me for 15yrs.  Anything they put out to the public or their peasants, read "clients", do the exact opposite.

[Rainman]

Anyone, anywhere daring to write a term like " more or less re-equilibrated " needs to be convicted of first degree bullshit, drawn and quartered and slung into a pit full of hungry dachshunds. 

[unwashedmass]

you know, at some point, these guys are going to grasp that they have stolen all the money....and the peasantry has none left for them to steal...or to spend to reignite the economy.

reading this, its clear they aren't there yet. but....a few more days of this, they'll get it.....and figure out a way to screw their clients with this "knowledge" (aka the ability to look out the window, realize its raining, and pull out a raincoat)

states across the country are cancelling summer school....peasantry can't pay their real estate taxes

california may go to four school days a week -- peasants can't pay their state taxes

the country is going to let the one million folks with expiring unemployment bennies die.....peasantry can't pay federal taxes...save the states...and give the Europeans the cash they need to save the euro all at once......

bingo......we have reached the tipping point. the peasantry is out of money, have no jobs, and can't pay taxes that can be funneled to the royalty (aka GS)....

game over.

[cossack55]

I'd say in brief,  that pretty well sums it up. 

[mister_x]

So many losing positions in that list. 

[unwashedmass]

by the way, thanks for putting this up. let's us all know exactly what NOT to do.....

you're doing us all a great service by helping us avoid having our assets confiscated by GS.

[jkruffin]

Like we didn't know this was going to be released

http://finance.yahoo.com/news/Fed-not-likely-to-sell-assets-rb-130716835...

[unwashedmass]

well back up the truck martha, let me buy some of that there Citibank. Jesus...they really think we're stupid.

[SilverIsKing]

C was up today...lol

[Hephasteus]

Of course it was up. It only goes down when someone other than the fed buys it.

[Racer]

GS ... oil going to $200 when it was over $100... it fell..oh how much?

enough to make it REALLY hurt if you were long

GS oil going to fall to sub $40... it doubled

enough to make it REALLY hurt if you were short

Thanks BS GS, I do not as you say.. you are con merchants

[TooBearish]

Those are some of the most convoluted OTC derivatives trades going....the bid/offer spread on some would probably represent any potential profit....go ahead not my money in a 1000 years

[williambanzai7]

PEARLS OF WISDOM FROM THE SACHS OF SHIT:

http://redwing.hutman.net/~mreed/Assets/blowhard.jpg

[pragmatic hobo]

world is definitely better if you are the top 1%. Just look at Blankfein ... paying cash for his new dig.

[AccreditedEYE]

Stupid Squid, your faith in your models will be your undoing...

[jkruffin]

Tyler, or any of the other moderators,  do you guys have any new info on the WAMU Option Arms or care to blog your thoughts on them?  I've heard several rumors, and read a couple posts in different places, that these things are getting ready to blow up in Dimon's face and bring Chase down to its knees.  Would be nice to see you guys data and take on what you expect to play out.

[mephisto]

And.... stopped out on the DAX.

300 points, 5%, lost in 10 trading days. Mmmm, I love the smell of fried squid in the morning.