Volatility Is Back
From Peter Tchir of TF Market Advisors
Volatility Is Back
Volatility is back. The S&P moved more than 1% on 4 of the 5 days, had the biggest down day of the year, and even the least volatile day was a 0.7% move.
Back on April 5th, we saw a warning sign in the credit markets that the bid/offer spread for European CDX indices was widening. This has extended into investment grade indices in the US where not every dealer maintains a ½ bp market anymore. That lack of liquidity, which has also been a factor in the sovereign debt market (especially for Spain) has hit the equity markets as well. We are seeing bigger moves on less information. I believe that this volatility will continue in the short term and that we will see at least one big capitulation to the downside in equities. The Nasdaq seems more susceptible to such a move since it is still trading above the 50 day moving average.
European stocks underperformed. That is likely to continue. The problems in Spain and Italy will be directed much more towards European institutions, and banks in particular this time around. Generically I like being long US financials versus short European financials, because although the entire market will get dragged down by renewed problems in the Eurozone, the correlation will not be as high as last time.
It is hard to talk about trading last week, particularly in the credit markets, and avoid the big JPM CIO trading story. I think that as details come out, the size of the position has been blown out of proportion. It will be much smaller than some of the headline numbers, and there will be long and short components and it will make a lot of sense both from a specific trade standpoint and also from a JPM business risk standpoint. I continue to believe that it is more in IG9 tranches, with hedges in HY, also possibly in tranches, and some curve trades.
In any case, the trade is still large and should raise concerns for regulators. The too big to fail argument is one obvious question that needs to be addressed. Is this trade for the “bank” or for the “investment bank”? For those looking for a much clearer segregation of the businesses run by JPM, this trade will be something they can point to. It is coming to light in a period of relative calm for the market, unprecedented support for banks from the Fed, and general disdain of bankers from the public in an election year. That could be what is needed to ignite a push towards a return to Glass Steagall or some other new legislation.
It may also be the straw that breaks the camel’s back in terms of pushing derivatives on to exchanges. This is something that should have been done immediately after Bear Stearns if not before, but for a variety of reasons (bank lobbyists) has been avoided up until now. The regulators should examine the whole chain of these trades. Who bought them and what they did with them? How many billions are sitting in mark to model books as opposed to having been traded? How much smaller would the trades been, and how much less would any distortion be, if every trade was on an exchange with a standard initial margin requirement and variation margin?
Regulators need to examine the whole series of trades, not just what JPM has on their books, and a renewed effort to develop proper exchange traded CDS needs to be done. None of the arguments against this have much credibility, as mark to model carries risk, and if the market has to shrink to support proper margin requirement, who really is hurt?
Jobs and Housing
The jobless claims this week were bad, plain and simple. I have seen arguments that more people quit, so it is “good” jobless claims, but since I have never seen a report detailing how many people were laid off but not eligible to make claims (which I think is a growing proportion of the workforce), I will largely ignore that positive spin.
Virtually every data point signals that the January and February reports overstated the real long term improvement in the economy. The jobs number is important, but mostly for what it could have meant to housing. Ultimately, we need the housing market to rebound to see the economy as a whole benefit, and that data lagged the job data all year long. The hopes were that somehow the jobs data was correct and housing would catch up. Now, it seems clear that housing was correct and jobs were overstated, so we may have a lot longer to wait for that housing recovery.
Without a housing recovery the market will struggle to go up much from here. It is too important of a sector, so it is hard to be bullish at these valuations with no real support from housing.
China and Europe
China disappointed this week. There is no landing yet so it is impossible to determine whether it will be “hard” or “soft”. I am leaning more and more towards hard, as I find it hard to believe the weak data reflects the whole truth, and there seems to be enough real concern about inflation in China and the state of the banks that more easing may be slow to come, and the pressure on the banks and property may come far faster than any new easing policy can stop.
Spain is in trouble. There is no liquidity for their bonds. Spanish 5 year and 2 year bonds now trade with higher yields than Italy. That was always the case in CDS, but the LTRO money and much smaller Spanish bond market had distorted that relationship in the cash markets. It is an ominous sign that those spreads have moved so much – as it shows that not only is LTRO no longer working for sovereign debt, but that the banks own too much and are better sellers if anything. The focus is on the 10 year, and the fact that it looks set to breach 6%, and that is bad, but this rapid normalization of the shorter end of the curve is possibly even more important.
Any fund that purchased these bonds leading up to LTRO2 is now facing a significant loss, and the lack of liquidity is scary. I do NOT think the ECB will step up in a meaningful way this week. The EFSF is supposed to take over secondary market purchases, and it is shameful that it doesn’t seem set up to do that yet, but there are other reasons that the ECB may not buy bonds. It is close to what it viewed as its limit for SMP, which leads to the obvious question of why didn’t they sell some bonds in the past month when the markets were hot? More importantly, the countries may not want the ECB to buy bonds if they are seriously considering a PSI. The ECB holdings were incredibly disruptive during the Greek debt negotiations and are the primary reason the restructuring has been a failure (any restructuring where the new bonds trade at 20% of par has to be deemed a failure). So don’t get too excited about possible ECB intervention.
There is some talk about Eurobonds (again) and various other possible programs to unite Europe, but I don’t see that happening any time soon. I think the strangest thing is that Spain agreed to 3% deficit target in the future. I never believed it would happen, but healthcare costs aren’t part of the Spanish deficit. No, in Spain, healthcare is largely a “regional” issue. That is why the regions are in such deep trouble. It is clear that no country in Europe counts for anything in the same way, and any of these “targets” is easily manipulated with some simple changes, and the use of “guarantees” as opposed to debt.
The Spanish debt load is looking like a “black hole”. You start with what seems a manageable sovereign debt to GDP ratio, but finally gravity is starting to pull regional guarantees, bank debt guarantees, off market swaps, and banks full of unrealized property losses, into the same spot. That “black hole” is not manageable and as realization hits, Spain can choose to struggle for years and capitulate down the road when things are much worse (like Greece did and Portugal is in the process of doing) or they can stop the nonsense and work out a proper debt restructuring plan now. This will hit European banks harder than any other sector.
I expect lower equity prices at some point this week. We may open with a bounce based on some IMF announcement or some ECB intervention, but this is why I think one more downleg:
- Spain in particular, and Italy to a less degree will weigh on the markets, dragging European bank shares down, and affecting the rest of the market
- Realization that the data in the US has been decidedly weak over the past month will finally overwhelm the market and those clinging to memories of January and February NFP
- QE in any of its myriad of forms is further away than the market currently priced in, the reaction to Yellen’s comments shows just how critical QE is to stock market valuation, but it is NOT critical to the economy and those concerned that it is actually hindering the economy are becoming more vocal, so QE expectations will take another hit
- Credit markets are becoming more volatile, less liquid, and not just in CDS and for banks, but across the board, this has been a consistent leading indicator of further weakness
- Weak data globally, and not just in the U.S. has been ignored so that will come into play making any sell-off that much worse
- AAPL. I have no real reason to dislike AAPL, but lots of “fast money” seems to be sitting on big profits and could choose to sell, and the price seems to have outrun what is actually being accomplished, it seems like it is being valued on I-Phone 7 sales, I-Pad 5 sales, and other future earnings while ignoring that everywhere I go, nothing is sold out or difficult to get – like it used to be. For this reason, I like Nasdaq to underperform. Also, if big companies start spending billions of their cash hoard in what might be viewed as a frivolous manner, then valuations for the entire sector can drop quickly.
As always we will see what the data comes up with, or whether any believable political, central bank, or supranational institution actions develop to change the view. I don’t expect anything dramatic, but could certainly see the S&P 500 pulling back towards its 100 DMA, now that is has breached the 50.