Mean Reversion

If the longs use VIX products as hedging instruments, then why would anyone take the other side? Because, being short volatility can be very profitable, according to Goldman. Year-to-date this short vol index is up 56%, and selling the front-month VIX has earned a massive 114 vol points... The introduction of weekly VIX futures (and the exponential decay implied by these volatility-inducing instruments) offers, according to Goldman Sachs, even more opportunity for active risk takers to sell vol, scrape premium, and face unlimited downside risk... playing the contango collapse game until there are no more musical chairs left.

...while the media gets overly excited about monthly job growth, the reality is that job growth has been little more than just a function of overall population growth. This isn't something the fosters long-term economic expansions that generate higher levels of prosperity... and if you think low interest rates necessitate high stock prices, that wasn't the case in the 1940s when interest rates were low and stock prices were below their long-term average relative to past earnings.

"Central bank distortions have forced investors into positions they would not have held otherwise, and forced them to be the ‘same way round’ to a much greater extent than previously... unless fundamentals move so as to justify current valuations, when central banks move towards the exit, investors will too.... The way out may not prove so easy; indeed, we are not sure there is any way out at all."

Bill Gross just revealed another aspect of trading in the new (or any) normal: one may get the direction and the timing with laser-like precision (as Gross did on his Bund trade), but if said trade is excecuted in a way where the inherent "coiled spring" volatility of the Gross-defined "new normal" blows up the trade structure, the losses will make one wish never to have had the correct idea in the first place.

The reality is, like dominoes, that once one of these issues becomes a problem, the rest become a problem as well. Central Banks have had the ability to deal with one-off events up to this point by directing monetary policy tools to bail out Greece, boost stock prices to boost confidence or suppress interest rates to support growth. However, it is the contagion of issues that renders such tools ineffective in staving off the tide of the next financial crisis. One thing is for sure, this time is "different than the last" in terms of the catalyst that sparks the next great mean reverting event, but the outcome will be the same as it always has been.

Over the past couple of years, there has been a growing chorus of individuals claiming that the financial markets have finally shaken the shackles of the secular bear market that began at the turn of the century. Bank of America is the latest to jump onto the "new secular bull market" bandwagon; but what they miss is that secular bull markets are not born of price, but rather of a set of fundamental metrics that foster sustained economic growth over long periods of time.

Just as we warned previously (here, here, and here), the knife-catching, contango-crushed, BTFDers that piled over $6bn into Oil ETFs have severely underperformed this year. The USO ETF has fallen by more than 9% since the start of the year, whereas front-month U.S. oil futures have dipped by less than 3% on account of roll costs, and as of last week, investors have started to exit this massive position en masse. As Reuters reports, outflows from four of the largest oil-specific exchange traded funds reached $338 million in two weeks to April 8 - the first since September and largest since Jan 2014. It seems Goldman was right about "misguided retail investors."

A five sigma event signifies extreme conditions, or an extremely rare occurrence. To bring this discussion from sports and weather to the financial world, we can relate a 5 sigma event to the stock market. Since 1975 the largest annual S&P 500 gain and loss were 34% and -38% respectively. A 5 sigma move would equate to an annual gain or loss of 91%. With a grasp of the rarity of a 5 sigma occurrence, let us now consider the yield spread, or difference, in bond yields between Germany and The United States. As shown in graph #1 below German ten year bunds yield 0.19% (19 one-hundredths of one percent) and the U.S. ten year note yields 1.92%, resulting in a 1.73% yield spread. This is the widest that spread has been in 30 years.

"Despite much hope that the current breakout of the markets is the beginning of a new secular 'bull' market - the economic and fundamental variables suggest otherwise. Valuations and sentiment are at very elevated levels which is the opposite of what has been seen previously. Interest rates, inflation, wages and savings rates are all at historically low levels that are normally seen at the end of secular bull market periods. Lastly, the consumer, the main driver of the economy, will not be able to become a significantly larger chunk of the economy than they are today as the fundamental capacity to releverage to similar extremes is no longer available."

With the "Great Greek Tragedy" now behind the markets, for the time being, all eyes have turned towards the Nasdaq's triumphant march back to 5000.  (The graphics department at CNBC have been working overtime on banners and bugs for when it happens....watch for them.) For now, it is all about the hopes of a cyclical upturn in the Eurozone economy supported by the ECB's QE program starting next month. Market participants have been bidding up stocks globally in anticipation that the ECB's program will pick up where the Fed left off, and the flood of liquidity will find its way back into asset prices

While there are many that suggest there is "no bubble" in the financial markets at the current time, a simple look at the extreme elevation of prices over the last couple of years is eerily reminiscent of the late 90's. Given the very elevated levels of investor bullishness, margin debt and complacency, there is more than sufficient evidence that a mean reverting event is highly likely at some point. However, at the moment, the perceived "risk" by investors is "missing the run" rather than the potential destruction of capital if something goes wrong. This is the opposite of what "risk" management is about...

"...I believe that the Fed understands that we are closer to the next economic recession than not. For the Federal Reserve, the worst case scenario is being caught with rates at the 'zero bound' when that occurs. For this reason, while raising rates will likely spark a potential recession and market correction, from the Fed’s perspective this might be the 'lesser of two evils.'"

At 30 basis points yield, a short on this German Bund via the futures market is basically a call option on the utter destruction of this Massive Yield Chasing Strategy on behalf of financial institutions...

The Fed has been supporting the market since the late 1980s. But there is an important difference between the actions of the Fed under Yellen versus Greenspan and Bernanke. In 2008, the Fed allowed Bear Stearns and Lehman Brothers to fail. Given the massive wipeout that followed, this decision is now viewed as a dangerous mistake. Having learned their lesson, the Fed is now rushing in to support the market in response to even routine 20% drops. In this way, the Fed is acting like a value investor who demands a small margin of safety before investing.... Since 2010, however, the Fed has changed tactics. The Fed is now reacting far more quickly. Small market selloffs are followed by immediate responses. By quickly riding to the rescue, the Fed is effectively front-running value investors.