Implied Correlation

Big Macro Discusses QE2 Impact On Pricing Power, Corporate Margins And Exporting Inflation Via The Renminbi Peg

Our friends over at Big Macro have put together the latest issue of their periodic newsletter. In this issue they look at the at seemingly inexplicable divergence between the VIX and the EURUSD 3 month implied correlation (never a good sign), the increasing delinquency rates across all consumer loan classes (as in buying but not paying, leading to companies like Netflix which made $7 million in cash in the quarter to have a market cap of over $8 billion), but most notably at the differential between commodity prices and the CPI, superimposed against inflation. What is uncovered is that while when unemployment is below 6% companies can increase prices faster than commodity prices can go up, at current levels of joblessness, it will be impossible to pass through surging input costs (whether these be in wheat, cotton, or rare earth minerals). This leads to the conclusion: "What does this mean for the inflation/deflation debate? If the FEDs QE program will continue to push up prices, companies can only squeeze their margins so much. The reason we are not seeing  inflation today is that there is a lag in the feed trough from commodity prices to consumer prices, partly because companies have been able to temporarily save their margins by aggressive cost cutting. I think we are potentially set up for a big decline in returns for equity investors." The last statement has a linear severity with the amount of free money that Bernanke floods in the market in two weeks.

Equities Go Full Retard As Rates Run For Cover

To see the prevailing schizophrenia gripping the two different sets of mindsets in the market right now, look no further than than the surging divergence between equity vol and implied correlation (VIX, JCJ) and credit vol (via swaptions: USSV011). The chart below shows that even as equity traders are going full retard into QE2, and expecting the Fed's Brian Sack to expense their purchases of such staples as hookers, booze and heroin next, rate guys are running for cove (guess what, the fact that going forward Americans will not pay mortgages again, likely for many months if not years, is not good news).

Paulson's Advantage Plus Fund Returns 12.5% In September, Flat For The Year

Paulson's largest Advantage fund, which managed $16.6 billion as of the end of Q2, and which was down 11% as of the end of August, has managed to ride the beta wave, which we expected in the beginning of September would miraculously come and rescue thousands of underwater hedge funds, and prevent tens of billions in redemption requests. As a result, Advantage pulled off a 12.5% return in September, outperforming the broader market 8.8% bounce over the same time period. Yet even with a gain of over $1 billion, the billionaire investor is just about breakeven for the year (in dollar-denominated terms), which taking high water marks and all that, likely means bonuses for all those analysts on the 50th floor of 1251 Ave of the Americas will be certainly subpar unless somehow the beta wave continues into the end of the year even as additional tens of billions in capital is pulled out by retail investors.

Frontrunning: September 24

  • CNBC's new pet blog is off to an unsurprising start: not only does it steal Zero Hedge stories without attribution, but apparently it discovered the entire correlation story - (NetNet). As a reference, Jeff, here are Zero Hedge's nodes on implied correlation going back into 2009, and here is our Nicholas Colas post. But yes, we also were very shocked someone out there read this to begin with. So keep stealing guys, nobody will catch it.
  • Two quotes of the day: "Irish debt agency CEO not worried about daily swings in bond spreads" and "Irish Finance Minister says concerned by yields in recent debt sales "
  • China Will Focus On Peaceful Development: Wen (China Daily)
  • China Takes Lead In Financial Deals (FT)
  • Spat Tests Japan's New Government." (WSJ)
  • Eurozone Crackdown On Public Finances (FT)
  • Spain Under Pressure to Show `Hair Shirt' Budget as Yields Rise (Bloomberg)

World FX Heatmap: Dollar Bloodbath

Remember those days when the dollar plunging (and the yen surging) meant a daily unwind in the carry trade, and a plunge in stocks? Neither do wo. Stocks are valiantly trying to confirm they are the most useless instrument ever, with bonds surging, gold skyrocketting, and stocks... about to go green (which is only due to increased speculation by MS as we pointed out yesterday, that the Fed will announce QE2 in one week). In the meantime, implied correlation in FX is starting to follow that of stock, as global capital flows are now one.

When Ignorance Is Bliss, The Recession Is Truly A Depression

With the market still drunk with hopium and grotesque stupidity from last week, after surging triple digits on an NFP number which was exactly as expected (returning strikers added 10,000 workers and the Birth-Death model, when accurately measured, contributed a net 17,000 jobs, so strip out these two effects and we actually end up with +40,000, which was bang on the consensus estimate) here is another reality check from David Rosenberg for all those who may be confused and believe that buying the "dips" or the market is in any way a prudent decision, when all it does is begs for someone to pull the rug from under the feet of speculators who believe that momentum and an implied correlation of 1 is indicative of improving fundamentals. Additionally, as nobody else seems to enjoy touching the topic, here is another observation on why we continue to live in a depression.

Third Hindenburg Omen Confirmation

The market is now down 3.4% from the August 12 open, when the first Hindenburg Omen was sighted, on route to validating the prediction of a 5% drop. However, in the process it continues getting worse and worse - today we just got a third H.O. confirmation, and a 4th standalone HO event, as the market seems to be getting ever more schizophrenic, with increasing new highs and new lows, while the undercurrent is one of ever increasing implied correlation as noted earlier, as ever more asset managers simply rely on levered beta "strategies" to redeem their year. Unlike 2009, however, this time the trick won't fly, as it appears the market's downside potential is finally starting to be appreciated.

Another Historic Milestone Passed As Implied Correlation Hits New Record

The 10 Year under 2.5%, Bunds, Gilts, JGBs all following suit to record risk-aversion levels, the EURCHF at record lows, the USDJPY at 15 year lows, and now this: the CBOE Implied Correlation index has just hit another historic plateau, touching on 85 earlier in the day, which means that all those who believe relative value can still be found are about to be carted off. Aside from the fact that the current level of JCJ would be the highest closing level in history, the intraday high of 84.50 is a very troubling indicator, which once again confirms that stocks continue to trade not on fundamentals, and probably not on technicals, but on ever increasing amount of leverage applied to some indication of beta. Essentially, market participants are likely levered to the gills like never before and betting it all on another daily Hail Mary. Another way of looking at the reading, as we have pointed out previously, is that stock dispersion: the most critical indicator of a healthy market, is at 15%! And let's not forget we are currently still in the H.O. regime (and to all naysayers we remind that the market has dropped almost 4% since the first Hindenburg Omen appeared). So many coincident records, can hardly be a coincidence... We look forward to getting Matt Rothman's thoughts on this increasingly disturbing trend, and for the NYT to pick up on this theme within 4-6 weeks.

Second Hindenburg Omen Confirmation In As Many Days, Third H.O. Event In One Week

Longs may be forgiven if they are sweating their long positions over the weekend: not only did we just have a second, and far more solid Hindenburg Omen confirmation today, with 82 new highs, and 94 new lows, but the Saturday is the day when Iran launches its nuclear reactor, and everyone will be very jumpy regarding any piece of news out of the middle east. As for the H.O., the more validations we receive, the greater the confusion in the market, and the greater the possibility for a melt down (or up, as the case may be now that the market is unlike what it has ever been in the past). Furthermore, with implied correlation at record levels (JCJ at around 78), any potential crash will be like never before, as virtually all stocks now go up or down as one, more so than ever before. And should the HFT STOP command take place, the future should be very interesting indeed (at least for the primary dealers, and the Atari consoles which are unable to VWAP dump their holdings in the nano second before stuff goes bidless).

Institutions Now Actively Selling Into HFT Permabid

Ever wonder why the SEC, FINRA and all other regulators actively continue to ignore the flagrant quote stuffing, frontrunning (yes, Flash trading is still a perfectly accepted practice) and all other destabilizing market activities facilitated and performed daily by High Frequency Trading (when comparable such actions result in jail sentences in Norway)? Hopefully the chart below will explain it...

With Long/Short Investing Dead, The Days Of LTCM Strategies Are Back As Market Plants Seeds Of Own Destruction

We have long observed the decline and eventual death of fundamental analysis, courtesy of i) the Fed's dominance of capital markets, ii) the emergence of HFTs and technicals as key driving forces behind the stock market, and iii) the record implied correlation between all stock asset classes, meaning everything trades as one. Ironically, the result is that reasonable, long/short investment strategies no longer generate a return (alpha or whatever one calls this relic of efficient markets), and instead we are back to the good old "pennies in front of a steamroller" strategy that was so "successful" and made so popular by such spectacular implosions as LTCM. Don't take our word for it - the FT reports: "The hedge fund strategy pioneered – and made notorious – by Long Term Capital Management is returning to prominence amid one of its most successful years yet, aided in large part by the massive issuance of bonds by the UK government and other sovereigns." In other words, the market is now stuck in a mode (courtesy of central planning) which guarantees that the only way to make money, sets the seeds of the markets' own destruction. It is only a matter of time before every investment strategy follows in the flawed footsteps of John Meriwether (who unfortunately can't participate in today's market due to three prior collapses, or else he would be making mint) and soon every single asset manager (not due to their own mistakes, but basically as a function of what the market rewards now) will follow a fate which will appear like an LTCM-like supernova in which every spread convergence trade explodes to historic divergence in a span of seconds. 

Dissecting The Flashing Red Warning Light Of Record Stock Correlations

As we pointed out on Friday, implied correlation closed at an all time high. While this phenomenon is likely the most concerning indicator of a wholesale market meltdown (not to mention that market neutral funds continue on their rapid progression to oblivion: for reference check HFRXEMN and HSKAX), more so than even the Hindenburg Omen (which however does make for a cool soundbite) as there are no endogenous safe-haven sectors within stocks (the safe haven is simply known as bonds, and stunningly high yield also applies even though HY, especially B2/B and lower, and stocks probably differ in some way, but we still haven't quite figured out what), the threat level will only be obvious in retrospect. The very curious topic has incentivized some in the sellside realm to present their own cautionary tales about the trade off and the cost-benefit analysis of a record high cross asset correlation. One among these is BNY's Nicholas Colas, who points out that due to the subliminal perception of record low stock dispersion (or liminal if such people read sites like Zero Hedge), investors have decided to diversify on their own not within stocks, but outside of stocks, the result being record inflows into bond funds (and outflows out of equities). His summary is very concerning: "Investors, even if they have not learned it formally, understand that diversification means lower correlations. As long as stocks, bonds, precious metals, and other assets all move in lock step, retail investors will most likely favor less risky assets." This statement captures the problem better than most: stocks, and their liquid, synthetic, nouveau-CDO cousins, the ETFs, continue to trade higher on ever greater vapors, as the underlying asset base is increasingly devoid of cash. And when the margin call-based liquidations set in, and they will, stocks will collapse more violently, and with far greater amplitude than they did on May 6 (incidentally a date which is an anniversary of the real Hindenburg disaster). Only in retrospect will the current record correlation levels be perceived for the loud alarm bell they truly are. But, courtesy of our idiot regulators, this will certainly not occur sooner, or before it is too late.

Charting Next Week's Bearish Action: Goldman Warns Of A "Meaningful Decline" In Stocks

Goldman's John Noyce (part of the firm's trading desk) has released his most recent barrage of technical analysis and charts, confirming our running expectation that a drop in stocks is now widely anticipated by the charts. In addition to extended commentary on FX, Bonds, Curves, and the VIX, Noyce notes the following on the S&P: "as discussed in recent client meetings, while the timing is difficult, we remain concerned that a larger topping structure is still being formed on the S&P – which will eventually lead to another meaningful decline." Has everyone, Goldman included, now gone from bullish to bearish in the span of two weeks?

Implied Correlation Closes At All Time Record High

It was only Wednesday when we were lamenting the collapse of alpha after implied correlation hit an all time intraday high of just under 80. Well, today should be the day when all long/short funds are shutting down: implied corr just closed at an all time record high of 79.57, after also posting an absolute intraday record of 80.08. It is getting ever more obvious that stocks continue to trade more and more as just one asset class, as seen by the constant increase in JCJ below, which has risen almost 15% in this week alone. At this rate, every stock will trade just like every other stock in under 3 weeks when alpha is officially put to rest and stock dispersion has undergone an extinction level event (better known as HFT and ETF encroachment, in which it is the price that determines value and not the other way around).