So you’ll understand my intent when I say “it’s different this time”. No really, it is. Consider the following chart of the VIX and credit spreads (as measured by the AAA to Baa spread on US corporate bonds):

To explain – we are going to compare the end of QE1 in March 2010 with the current environment. The numbered inflection points provide the backdrop;

(1) The VIX made a low of 15.73 on 20 April 2010 (all prices are at the daily close) – while the S&P500 made its high on 23Apr10.

(2) The VIX high of 45.79 was recorded on 20 May 2010 – the S&P500 made a low on 2 July 2010.

(3) The VIX registered a low of 14.62 on 28 April 2011 – the S&P500 reached its high on 29 Apr 2011.

This all seems pretty consistent – the VIX leads the S&P500 by a day or thirty. So what if we haven’t actually finished with QE2 yet? We all know what happened next – seems reasonable that the exits would be rushed a little sooner this time.

Then what to make of the CBOE put/call ratio? It’s been trending higher since Christmas which is hardly consistent with previous instances of extreme bullishness before the fall.

If anything, volumes suggest that it’s contracting demand for calls that has been dragging the ratio higher. While this indicator is a bit of a blunt tool, as it says nothing about the shape of the volatility smile nor the nature of options being exchanged, it does clearly indicate that volume is on the wane.  This is a trend reflected in NYSE volume incidentally.

In any event, while the VIX may be an imperfect measure, it does have form in anticipating turning points. This is the reason why we keep an eye on the following charts:

Note the same inflection points as noted earlier.  At (1), the S&P500 as implied by the VIX, failed to confirm the actual indexes high, and the actual index promptly sank 200 points. And (2), following the low in the VIX in May, the implied S&P index marked out a long positive divergence against the actual index – which ultimately followed it higher.

So we get to the more curious current events. Not only did the S&P500 as implied by the VIX make a new high on 19 May 2011 well after the high in the actual, the implied has failed to make any new low on the downside with the most recent weakness.

Now maybe this divergence is simply indicating that this measure is broken. It’s a reasonable argument – that QE has distorted option market activity by encouraging the selling of ATM risk while buying the wings. Maybe. But it never hurts to have an open mind…

At least, we can’t argue with the statement ‘it’s different this time’.

Moves of that magnitude in the VIX are relatively rare. Looked at over time it’s notable that apart from the cascade of selling into the 2009 lows, there have been few occasions over the last three years where equities have trailed moves in the VIX by a similar margin. (By way of explanation, the chart compares the actual move in the S&P500 to that implied by the same day’s move in the VIX – based on the above linear regression of the relationship over the period.)

The last time that we saw an unaccompanied VIX spike was into the market pullback in April 2010. Given that the red lights have been dominating the control board over the last month or so, this all got me to wondering whether we are setting up for a test of the Fed financed bid – even before we run out of QE2 fuel-rods.

Certainly, when viewed through the lens of the putcall ratio, there is plenty of similarity between today’s market and that prior to the pullback last year:

It’s interesting then that looking to a breakdown of option volume, that the spike in volatility looks to be a result of heavy buying of both calls and puts – and that this too is analogous to the April period last year:

Without reading too much into these broad brush measures, these seem to be confirming that upside ambitions have been stretched to the edge of the historical envelope leaving equities vulnerable to a near-term pull-back. Still, the preponderence of call buying and the resilience of the index, suggests the market remains cautious of leaping headlong into the reactor. With up to $29bn of Treasuries to be acquired this week, it’ll be interesting to see how the market wades through the creeping uncertainty.

With volatility threatening to settle into new lows for the year, the idea of a cheap hedge has particular resonance. Notwithstanding that the long break is upon us, a veritable black hole of time decay, recent market action suggests that options may be approaching reasonable value.  A quick look at the VIX will confirm that it is trading back towards levels that have marked the bottom of its trading range in this post-GFC world:

Notably too, the CBOE put/call option ratio has pushed into territory that is rarely seen.

There is nothing in the rule book that says that this ratio can’t go lower still, nor that it can’t simply hang around these levels for an inordinately long time. The point is simply that the equity options market has pushed to historically extreme bullish positioning. We can see that it has been call buying that has driven the ratio lower:

While this ratio can often be viewed as a contrarian indicator, this is not to say that the market must immediately embark on a new leg down. For that to happen, the Fed needs to change its strategy – or have it changed for them. The current over-bought and over-bullish conditions could conceivably be unwound through the market simply trading sideways for a month or three.

Rather this thinking follows more from the logic that the risks are assymetric in the markets at present. While recent profit upgrades by the likes of Goldman’s may come to pass, there is little to suggest that the macroeconomic pin risks associated with debt deleveraging are behind us. On the contrary, high debt levels across the landscape remain the inescapable issue facing governments globally. On this basis, cheap protection has a strong appeal.

Consider where the CBOE put-call ratio was at the start of quantitative easing proper – when global liquidity was truly in a catatonic state:

While the ebullience that marked the first half of the year has subsided somewhat, current conditions are hardly indicative of an all-out squeeze.  It’s also interesting is that looking to the breakdown of the ratio, the volume in both puts and calls has fallen to levels not seen since Dick Fuld had the keys to the gym.

My sense is that it is wishful thinking to imagine that we have passed beyond the volatility that has characterised the last couple of years.  Maybe fatigue is setting in – people have just lost interest?  More likely we are passing through the end of one cycle and into another.  The government inspired rally in risk expired some months ago, until the next round of stimulus money gets put to work, the pull of debt deflation will have its way. No wonder Treasuries have been pushing to new lows – even dragging lesser credits in their wake:

Chances are that the risk curve will splinter once the motivation for the move in long yields is recognised.  A balance sheet recession is not good for anything but the most pristine of safe havens.  Volatility is cheap around current levels…it’s just a matter of theta.

When we last reviewed our risk measures (on 3 June here), we suggested that the augurs were in favour of such a rally.  The subsequent sedation can be seen in our risk appetite index:

Similarly, the CBOE putcall ratio has stabilised and is likely to trend lower still:

However, that credit spreads continue to march wider indicates that there has been a fundamental shift in the calibration of risk.  If we look to shorter term interbank swap rates the same trend prevails – EURIBOR and LIBOR looked to have bottomed in April coinciding with the peak in equities.

For mine, the working thesis is that we are in the second leg of a rally that should take us into early July.    As forthcoming economic releases continue to portray a global recovery running out of steam, we might expect that fear will once again begin to surface.  In any event, we’ll reassess the lay of the land when we get there.

If history is any guide, the 10 day moving average of the CBOE putcall ratio should gravitate towards the 60 level.  If we see the daily ratio close in the 40′s then that will be as good a signal as any that optimism has poked its head above the rails.

Similarly, it’d be reasonable to expect that the VIX will track back through to the mid-20′s which has historically proved a pivot point.

Assuming these events come to pass, then the S&P500 should have pushed back to around 1150.  In any event, will be interesting to watch how volume evolves over the course of the next few weeks – distribution into a rally would suggest that it’s time to batten down the hatches once again.

1) Elevated volumes are generally followed by a period of reflection while markets assess the damage:

2) Similarly the CBOE PutCall ratio has moved very quickly from historical lows:

3) And our risk appetite index, that measures the relative pace in the change in risk appetite, has blown out to levels not seen since Lehman’s ventured into the hadron collider:

With technical reversals in the USD and WTI overnight, and momentum waning in gold’s advance, the indications are that risk markets will at least consolidate and perhaps even test their legs against the recent trend.  However, with Chinese equities still on the nose and the CRB plummeting overnight, we have no all clear signal to re-enter the risk trade.  As equities are still in overvaluation territory, and with credit spreads digesting the deteriorating risk environment, there is no need to rush back into the fray.

So a quick review of some of our risk indicators:

The VIX and credit spreads have been flirting around new lows for the last couple of weeks – until Friday that is.  Whether it was the Goldman news, or the selloff in Google et al that preceeded the said news, volatility took a turn for the worse.  Still with the VIX at 18.46 at the close there is plenty of room for a bigger correction – based on the trading range pre-Lehman’s, a spike towards the high 20′s is a reasonable proposition.

And what might drive such a move?  The complacency in the market has been extreme of late meaning there is plenty of dry tinder lying about the place – witness the 20 day moving average in the CBOE PutCall ratio making new lifetime lows:

Another indicator that this selloff is likely to get up a head of steam is that volume spiked on the S&P500 on Friday – to its highest level since the indecision of May last year.  History would suggest we can expect a few more high volume days – and they are typically down:

Another indicator to watch is the carry trade.  For example, AUDYEN had been treading water for some considerable time failing to match the upside momentum in risk assets.  It broke down on Friday, with plenty of room for a deeper retracement:

We could also look at indicators like emerging markets and commodities to see how they are faring.  Suffice to say, John Taylor’s reading of the entrails might prove to be pretty timely.  For mine, will look to add some long-side risk exposure if our doe-eyed risk index tips back through its recent February lows.

]]> http://www.datadiary.com.au/2010/04/19/forecast-a-serious-bout-of-risk-aversion-with-acid-rain-over-europe/feed/ 7 http://www.datadiary.com.au/2010/04/07/why-is-that-red-light-blinking/ http://www.datadiary.com.au/2010/04/07/why-is-that-red-light-blinking/#comments Tue, 06 Apr 2010 22:59:51 +0000 Rohan Clarke http://www.datadiary.com.au/?p=1958 Signs of imminent turbulence ahead for the equity markets – consider the following:

• Marketbeat notes that 52 week highs have rolled over – as happened in January this year and October last
• Molecool via The Slope of Hope notes that ISEE equities only closed just short of all time highs
• Along similar lines, VIX and more notes that the 21-day average of the CBOE PutCall ratio is near all time lows

Sentiment pushing extremes and momentum waning…

Then we have the view that various markets are pushing up towards critical levels – see Nic Lenoir via Zero Hedge. Maybe we get a final push higher to trigger the much watched bollinger band reversal on the VIX – and then a selloff?

While I’m linking here – The Humble Student of the Markets provides a neat summary today of his near term and longer term outlook. Couldn’t agree more.

1) Extremes in risk appetite often signal the exhaustion of a trend

Our market-based measures of risk appetite are coincident indicators, that is, changes in investor sentiment will be immediately reflected in prices and/or volumes. When aggregate investor sentiment is leaning heavily one way or t’other, the relevant measure of risk appetite will reflect this.

Particularly in the shorter term then, extremes in sentiment often signal that the current trend is vulnerable. If the market is overweight a consensus view, the risk of a stop-fuelled counter-trend move is heightened.  For this reason, indicators such as the CBOE put call ratio are often useful as short term windvanes – consider the current market position:

Once again, the ratio is testing lows that generally signal that bullishness is at an extreme and caution is warranted.

Volume can also be useful in this regard.  Consider this chart of the S&P500 and 10dayMA trading volume.

Spikes in trading volume higher generally occur at or around price lows in the index.  Notably, the common criticism that the current rally has been built on declining volume (and therefore is not confirmed by volume) is pretty clear from the above.  Just that when placed in this longer term context, it looks like rallies are more likely to be lower volume that selloffs regardless of their place in the economic cycle.

2) The absolute level of risk spreads can indicate which sectors are likely to outperform

To state the bleeding obvious – the absolute level of risk spreads are a reflection of the prevailing environment – the challenge is to decipher whether they are appropriate for the future environment.  Changes in risk spreads are after all key drivers of prices.

For example, in a credit bubble world, where interest rates are low, cash is plentiful and ‘benign’ is the prevailing mood, risk spreads of all hues will be bid in as money chases returns. The risk curve flattens, credit spreads are low and stable while equities outperform.  Conversely, when the risk curve is steepening due to rising defaults and with financing costs on the rise, equities will underperform. An interesting study in this regard by EconoPic illustrated that the absolute level of risk spreads might be a good indicator of 1 year forward returns as between equities, high yield debt and investment grade debt.

So what we want is a do-it-yourself roadmap, so we can assess which sectors are likely to outperform if risk spreads move to reflect that world. In this context, the current level of risk spreads are expressing some optimism. Credit spreads (as between AAA and investment grade corporates) are threatening levels not seen since the last days of the bubble, while the VIX has returned to the lows of May 2008. These are suggesting that we are well and truly through the crisis.

If you believe that that we are tracking to muddle through with global liquidity being maintained to support the recovery, perhaps you can argue that credit spreads and the VIX can keep tightening. For mine, in a world where the recovery has peaked, and the threats from sovereign debt defaults, rising trade tensions and ongoing assets problems are clear and present dangers, the ongoing push up the risk curve looks less likely to be favourably rewarded from here on in.

In short, I’d see the fair value risk curve as being north from here – and steeper.  For example, this means a range trade on the AAA-Baa spread of between 100 and 150 bps.  Pushing further out the risk spectrum, equities are also likely to be defining the top end of a range – with a material risk of a deeper risk aversion trade that takes us back to the long run moving average of the S&P’s P/E multiple.