Volatility

Two weeks ago when we posted "The Kangaroo In The Metals Mine: Fortescue Trying To Raise $1.5 Billion From 20 Banks As Iron Prices Implode" we observed several developments in the bond prices of Australian mega iron miner, and fourth largest in the world, Fortescue, which suddenly found itself in dire need of cash which is always a first step to insolvency, which made us comment that just "like that we are back to those days of 2008 when the Chinese demand collapse meant any day could be FMG's last. Happy days are back again." Not really. We added that "as usual, the bond market is the first to get the memo that the landing is going to be a hard one. We give the farce that is known as equities about 4-6 weeks before they too get the memo." We were actually wrong: it took just two weeks for equities to finally figure out what we were warning about. From Reuters: "The world's no.4 iron ore miner Fortescue Metals Group Ltd has asked lenders to waive debt covenants if iron ore prices remain under pressure, the firm said on Thursday, after its shares suffered their worst loss in almost four years. Like other Australian miners, Fortescue's earnings have come under pressure from a plunge in commodity prices caused by weak demand in top consumer China. This has squeezed its ability to service its long-term debt, which stands at $11.3 billion." Of course, those who read our August 31 report, and were positioned accordingly and ahead of the market, made 20% in two weeks.

While this and that may have happened overnight, the only thing that matters today is what the FOMC presents to a market which has now priced in well over 100% of a new easing round. Except little movement until Bernanke speaks, and with that removes any doubt that i) the Fed, like the ECB, are both political creations comprised of unelected academics, and ii) the entire modern capitalist world is nothing but a Pavlovian creation that responds only to promises of liquidity injections. Luckily, if nothing else, this will once and for all shut up anyone who claims that the market reflects the economy, it doesn't; that a "virtuous economic cycle" is possible under the new centrally planned normal, it isn't, and that the US economy is recovering 4 years after Lehman collapsed. It never did, and without $14 trillion in central bank liquidity injections over the same period, the world, as represented by the S&P, would be in a mindblowing depression, which it will still get back to once the surge in hard asset inflation offsets any incremental liquidity provided by the central planning academics as Citi warned yesterday.

Central bank demand internationally continues and demand for gold in the increasingly volatile Middle East remains robust as seen in data from the Istanbul Gold Exchange. It showed that Turkey’s gold imports were 11.3 metric tons last month alone. Silver imports were 6.7 tons, the data show. Much of these imports may be destined for Iran where imports have surged an astonishing 2,700% in just one year – from $21 million to $6.2 billion. In the first seven months of this year, Turkey's exports to Iran have also skyrocketed to $8 billion, up from $2 billion in the same period last year. And it is widely believed that the major portion of the increase, which is $6 billion, stems from the export of gold. There is speculation that the Iranian central bank is buying gold and that they may be accepting gold in payment for oil and gas in order to bypass western sanctions.  Turkey is paying for the oil and natural gas it is importing from Iran in gold, Turkish opposition deputies have claimed, drawing attention to the enormous increase in Turkey's gold exports to Iran in 2012.  “Gold is being used as an instrument for payment. Under the guise of exportation, gold is being sent to Iran in exchange for oil,” Sinan Aygün, a deputy from the Republican People's Party (CHP), has told Turkish daily Today's Zaman.

One of the deepest mysteries related to the ongoing rally in U.S. equities is the persistent lack of retail investor involvement. QAs we have vociferously noted, U.S. equity mutual fund flows remain solidly negative and interest in single stock trading among individual investors is similarly moribund - while corporate bond volumes remain flat and Treasury volumes higher.  As Nick Colas, of ConvergEx group, notes, one missing link to explain this dichotomy must be the fundamental lack of financial literacy among U.S. retail investors, yet this relationship is seldom mentioned as a reason for this group’s ongoing apathy in the face of 4-year highs for domestic stocks. You might argue that “It was always thus…” and that is a fair point.   American investors haven’t grown dumber on financial matters in the last decade; they never had the requisite knowledge to begin with.  But it does appear that the events of the last few years have caused some kind of “Tipping point” with regard to investors’ ability to process the world around them.

The fundamental backdrop, in the shape of economic lead indicators and earnings momentum, has been deteriorating: manufacturing PMIs for the US, China, Japan, Korea, the Euro zone, and the UK are all now sub-50, and consensus earnings growth estimates for 2012 have been halved in recent months. What has this meant for Global Equities? Well, as UBS notes, in the last three months, very little. The MSCI AC World index is up more than 12% from the 4 June low. That markets have rallied while fundamentals have deteriorated in this manner is unusual. Historically, equity market rebounds have tended to coincide with a trough in PMIs and earnings momentum – that is, when PMIs have stopped going down and the pace of earnings downgrades slows (waiting for PMIs to recover to 50 or for earnings momentum to turn positive is usually too late). Markets now appear to be taking their cues from central bankers: potential policy actions are becoming a sort of ‘lead indicator of the lead indicators’, if you will. Given the recent rally, in addition to underlying macro weakness, policy action - and effective action at that – has become increasingly important for investors. Without it this recent rally could end up looking more like a false start than a head start.

Ah, hmm, yes, Greece… Not much else to chew on.

Risk is lofty and near the point where all stimulus measures that were already priced have been delivered.

So, what's next?

The unremitting deterioration of the eurozone’s sovereign debt landscape continues to fuel uncertainties about the longevity of the euro as a hard currency. Such uncertainties are not only leading to capital flight from the EMU’s periphery to the core and destabilizing markets worldwide, but they are also beginning to frighten southern European savers into seeking refuge outside their 10-year-old currency. Such is the case of Spain – the latest tumbling economy to threaten the euro’s survival. As the crisis deepens, there is still a window of opportunity for Spaniards to turn to gold as a means to protect their wealth against the risks of increased foreign exchange volatility, forced re-denomination, or even a total currency collapse.

Last August, a 400 point move in the DJIA was the norm. This August, a 50+ point drop in the second coming of the "Balls to the Wall" DJIA was the green light for sheer market panic. While unknown if it is the cause, or effect, of this collapse in volatility, the NYSE just reported that August cash volumes imploded by exactly 50% from last year, one thing is certain: for banks, which no longer make money on net interest margin courtesy of ZNIRP, and $1.6 trillion in inert reserves, the bulk of which are used to buy TSYs, then promptly repo them back to the Fed and use the cash proceeds to buy 200x+ P/E stocks, imploding stock volumes mean only one thing - a collapse in revenues and profits, terminations of entire divisions, collapse in tax revenues for the US Treasury, an increase in deficit, the need for more debt issuance, and a green light for the Fed to monetizing even more supply. And just to avoid the noise from "unseasonal" Y/Y comparisons, in August total ADV dropped by 12.6% from July. ETF volume imploded by two thirds from last year, and 14% from last month. Cue the financial earnings forecast reductions ahead of Q3 results.

So what's driving these high ass oil prices? Fundamentals, paper pushing derivatives, fraud, or fear? A common sense discussion ensues...

As Elvis (oops) Jerry Lee Lewis might have said if he were a trader "there's a whole lotta shakin' going on" but not much else. Cross asset-class correlations were weakening, ranges were very narrow today in stocks, credit, Treasuries, commodities, and FX, and volumes were well shrug. The three biggest items of note to us were among 'leadership' assets: AAPL dropped rather notably into the close - ending -0.7%; HYG (the high-yield bond ETF that has been so flow-/yield-grab-driven) dropped significantly into the close (saved by a last minute rescue) after heavy volume at the close last night and relatively heavy today as we sold down; and the major leveraged financials GS and MS - soared intraday (GS>MS) far exceeding their peers - but MS gave a significant amount of it back into the close while GS kept pushing up (+3%) with some major volume and VWAP action. Everyone is waiting for the great and good Draghi to anoint this rally tomorrow morning but the last hour pull to VWAP in S&P futures was not followed by VIX, as we note today was the lowest average trade size (amateurs) day of the year in S&P futures.

Monetary Outright Transactions - MOT

Moths??? Like those burning up on light bulbs??? Or like in “to mothball”, buy and store?

It is amazing how big an effect a rambling, sleep-inducing speech by a chief central planner can have on financial markets in the short term. Nonetheless, the speech contained a few interesting passages which show us both how Bernanke thinks and that people to some extent often tend to hear whatever they want to hear. Bernanke noted that although he cannot prove it, econometricians employed by the Fed have constructed a plethora of models that show that 'LSAP's (large scale asset purchases, which is to say 'QE' or more colloquially, money printing) have helped the economy. In other words, although no-one actually knows what would have happened in the absence of the inflationary policy since we can't go back in time and try it out, the 'models' tell us it was the right thing to do. However, some indications would suggest that mal-investment is higher than ever - and accelerating - as the production structure ties up more consumer goods than it releases, an inherently unsustainable condition; additional expansion of money and credit will only serve to exacerbate the imbalance.

There is still some compression margin, but where to put the credit spread, real or “perceived”, from a (real) default possibility point of view or even from the shunned convertibility point of view?

Since the peak in the S&P 500 around two weeks ago, equities and their sectors have traded in a considerably more disperse manner than one would expect given all the talk of central-bank intervention, liquidity-gasms, and monetization. This is borne out empirically as the average pairwise realized correlation within the 100 stocks of the S&P 100 and the 125 credits of the CDX investment grade credit index has dropped dramatically. Extreme peaks or troughs in realized correlation have tended to coincide with notable (and tradable) trend changes in the market - though we note, as shown below, that the moves are not always so clearly bullish or bearish for stocks (though VIX shows a more consistent reaction). Critically, the outperformance of Healthcare and underperformance of Industrials and Materials in the last two weeks suggests more than a little apprehension at the Central Banks being able to 'bridge' yet another global slow-down with money-printing.

Europe took August off. Today, it is America's turn, as the country celebrates Labor day, although judging by recent trends in the new 'Part-time" normal, a phenomenon we have been writing about for years, and which even the NYT has finally latched on to, it would appear the holiday should really be Labor Half-Day. After today the time for doing nothing is over, and with less than one month left in the quarter, and trading volumes running 30% below normal which would guarantee bank earnings in Q3 are absolutely abysmal, the financial system is in dire need of volume, i.e. volatility. Luckily, things are finally heating up as the newsflow (sorry but rumors, insinuations, innuendo, and empty promises will no longer cut it) out of various central banks soars, coupled with key elections first in the Netherlands and then of course, in the US, not to mention the whole debt-ceiling/ fiscal cliff 'thing' to follow before 2012 is over. So for those who still care about events and news, here is the most comprehensive summary of the key catalysts over the next week and month, which are merely an appetizer for even more volatile newsflow in October and into the end of the year.