The Perfect Storm (Of The Coming Market Crisis)

Authored by Lance Roberts via RealInvestmentAdvice.com,

It is always refreshing to step away from the keyboard for a few days and hit the “reset button,” which is exactly what I did last week. My wife and I took a quick trip to Mexico to get a little sun on our face while we wiggled our toes in the sand.

I came back astonished.

Over my 30-odd years of working with money in various capacities, I learned to “shut-up and listen.” This is particularly the case when you are in an airport lounge or packed like sardines in a missile-shaped tube hurling through the air at 35,000 feet.

People love to talk…if you let them.

I had a dozen “listening sessions” with a wide variety of people who each told me roughly the same thing summarized as follows:

1. The market is a “can’t lose” proposition.


2. So is “Bitcoin” (even though they had no idea what it really is when I asked them.)


3. The market is only going higher from here because the Fed won’t let it go down.

You get the idea.

And just when I thought I was sure I had the most bullish views wrapped up – Kevin Matras fro Zack’s Research hit my inbox with the following:

“The S&P will double. And not just eventually. But over the next 5 years (or sooner).

 

Sounds like a Herculean task on the surface, but it’s really not. In fact, the market only needs to gain on average of 14.9% per year in order to do so. That’s not such a stretch given the market has been averaging 14.9% per year since this bull market began in early 2009, even though GDP (prior to this year) has only been increasing at an anemic 1.48% annual rate.

 

My 5-year doubling thesis also means that we won’t see another recession until stocks double again, nor will we see another bear market until stocks double again.“

So, there you have it.

No bear market until the market racks up another 2600 points and dwarfs every other economic growth cycle in history.

Meanwhile….Back On Earth

Before I go further, let me clarify one thing.

As a portfolio manager, I am neither bullish nor bearish. I don’t really care which way the market is headed personally. If it is rising, as it is now, I am long equities. When it reverses that trend, I will either be short equities and long bonds and cash.

That’s my job.

My job is also to pay attention to the risks that could quickly remove large chunks of investment capital from my client’s portfolios. Like any professional gambler knows, you can only play the game as long as you have a “stake” to play with. Lose your capital, and you lose the game. 

The Perfect Storm Cometh

In the movie, “The Perfect Storm,” George Clooney plays the Captain of the “Andrea Gail.” The Captain, after having a bad start to the fishing season, convinces his crew to go out one last time and they venture well past their usual fishing grounds leaving a developing thunderstorm behind them. After ignoring repeated warnings, a desperate Captain, and crew, head into a confluence of two powerful weather fronts and a hurricane in order to cash in on their bounty.

They all died.

Investors today, after having missed out on the first few years of the current bull market cycle, have now decided to throw all caution to the wind and ignore the repeated warnings in hopes of attaining the “riches” they have been promised.

And, like the “Andrea Gail,” they are currently heading into a perfect storm.

Storm One

Currently, there are many articles pointing our various risks in the market. One that caught my attention over the weekend was a note on the volatility index by Kevin Muir.

“For the longest time, I felt the concerns from the VIX were overblown. For years, market pundits have been bandying about charts meant to scare investors about the potential dislocation in the VIX market. I even wrote a piece called, The VIX Article no one will like.”

He is right.  For the last several years, each time the volatility index hit new lows, there were fears of a massive reversal on the horizon. Yet stocks marched higher while the volatility index made even lower lows.

But Kevin goes on to make an important point:

“Yet the frenetic pace of VIX shorting has intensified to a level that frightens me. There is now $1.2 billion of market cap of the inverse VIX ETF XIV, with another $1.3 billion of SVXY (another inverse ETF). This is insanity.

 

If we get a sharp move higher in VIX, there will be a snowball effect. If it is big enough, monster positions, like $2.5 billion of short VIX ETFs will have to be bought back in a hurry. And let me break it to you, there is no one large enough to take the other side of that trade. At least no one willing to do it without extracting many pounds of flesh first.”

Kevin is absolutely correct.

The only question is how far does it have to rise before the “margin calls” begin to occur. More importantly, volatility runs very long cycles which, unsurprisingly, follow the psychological investment cycles of the market from fear to greed back to fear.

But that is not the only problem.

Storm Two

Once the $VIX trade begins to fail, investors will find themselves almost immediately confronted the “high-yield bond storm.”

American corporations are levered to the hilt with total corporate debt surging to $8.7 trillion – its highest level relative to U.S. GDP (45%) since the financial crisis. In just the last two years, corporations have issued another $1 trillion of new debt NOT for expansion but primarily for share buybacks to boost bottom line earnings per share.

Note: This is also why “repatriation” won’t lead to massive economic growth, wages or employment. Instead, it will go to share buybacks, dividends, and executive compensation. 

For the last 9-years, the Fed’s “zero interest rate policy” have left investors chasing yield and corporations were glad to oblige. The end result is the risk premium for owning corporate bonds over U.S. Treasuries is at historic lows.

I have written for some time that during the next market reversion, the 10-year rate will fall towards “zero” as money seeks the stability and safety of the U.S Treasury bond. However, corporate bonds are an entirely different issue. When “high yield,” or “junk bonds,” begin to default, as they always do, which is why they are called “junk bonds” to begin with, investors will face sharp losses on the one side of their portfolio they “thought” was supposed to be safe. 

Let the panic selling begin.

As shown below, when the rout begins, the yields on junk bonds sharply deviate from that of the U.S. Treasury bond. Again, the 10-year Treasury rate is not going higher anytime soon, but everything else likely will.

Storm Three – The Hurricane

Of course, as investors begin to get battered by the “volatility and junk bond storms,” the subsequent decline in equity valuations begins to trigger “margin calls.” 

As the markets decline, there will be a slow realization “this decline” is something more than a “buy the dip” opportunity. As losses mount, the anxiety of those “losses” mounts until individuals seek to “avert further loss” by selling.

There are two problems forming.

The first is leverage. While investors have been chasing returns in the “can’t lose” market, they have also been piling on leverage in order to increase their return.

It is often stated that margin debt is “nothing to worry about” as they are simply a function of market activity and have no bearing on the outcome of the market.

That is a very short-sighted view.

By itself, margin debt is inert.

Investors can leverage their existing portfolios and increase buying power to participate in rising markets. While “this time could certainly be different,” the reality is that leverage of this magnitude is “gasoline waiting on a match.”

When an “event” eventually occurs, it creates a rush to liquidate holdings. The subsequent decline in prices eventually reaches a point which triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying “collateral,” the forced sale of assets will reduce the value of the collateral further triggering further margin calls. Those margin calls will trigger more selling forcing more margin calls, so forth and so on.

That Sinking Feeling

Unwittingly, investors have compounded their risks by piling into exchange-traded funds under the mistaken assumption it is an “easy way to invest.”

Over the past 9-years, the number of ETF’s available to investors has now eclipsed the number of stocks available for them to invest in. This leads to a liquidity problem and the risk of a “disorderly unwinding of portfolios.” As the head of the BOE, Mark Carney, warned:

“Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.”

The issue of liquidity is not a small one.

Investors mistakenly assume there is ALWAYS a buyer at the price at which they wish to sell. 

This is wrong.

While the answer is “yes,” as there is always a buyer for every seller, the question is always “at what price?” 

At some point, that reversion process will take hold. It is at that point where the storms all collide into a massive wave of panic driving selling. It will not be a slow and methodical process, but rather a stampede with little regard to price, valuation or fundamental measures.

It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s, junk bonds, and option pricing. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Don’t believe me? It happened in 2008 as the “Lehman Moment” left investors helpless watching the crash.

Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.

Currently, with complacency and optimism near record levels, no one sees a severe market retracement as a possibility. But maybe that should be warning enough. 

Where the majority of mainstream punditry gets it wrong, in my opinion, is they keep saying we “can’t have another ‘great financial crisis’ again” because things are different.

That’s true.

NO market “mean reverting” event has EVER been based on the same issues that caused the previous event.

The next event won’t be the same as any past event either.

Only the outcomes remain the same.

The “perfect storm” is coming.

"People Ask, Where"s The Leverage This Time?" - Eric Peters Answers

One of the Fed"s recurring arguments meant to explain why the financial system is more stable now than it was 10 years ago, and is therefore less prone to a Lehman or "Black monday"-type event, (which in turn is meant to justify the Fed"s blowing of a 31x Shiller PE bubble) is that there is generally less leverage in the system, and as a result a sudden, explosive leverage unwind is far less likely... or at least that"s what the Fed"s recently departed vice Chair, and top macroprudential regulator, Stanley Fischer has claimed.

But is Fischer right? Is systemic leverage truly lower? The answer is "of course not" as anyone who has observed the trends not only among vol trading products, where vega has never been higher, but also among corporate leverage, sovereign debt, and the record duration exposure can confirm. It"s just not where the Fed usually would look...

Which is why in the excerpt below, taken from the latest One River asset management weekend notes, CIO Eric Peters explains to US central bankers - and everyone else - not only why the Fed is yet again so precariously wrong, but also where all the record leverage is to be found this time around.

This Time, by Eric Peters

“People ask, ‘Where’s the leverage this time?’” said the investor. Last cycle it was housing, banks.

 

“People ask, ‘Where will we get a loss in value severe enough to sustain an asset price decline?’” he continued. Banks deleveraged, the economy is reasonably healthy.

 

“People say, ‘What’s good for the economy is good for the stock market,’” he said.

 

“People say, ‘I can see that there may be real market liquidity problems, but that’s a short-lived price shock, not a value shock,’” he explained.

 

“You see, people generally look for things they’ve seen before.”

 

“There’s less concentrated leverage in the economy than in 2008, but more leverage spread broadly across the economy this time,” said the same investor.

 

“The leverage is in risk parity strategies. There is greater duration and structural leverage.”

 

As volatility declines and Sharpe ratios rise, investors can expand leverage without the appearance of increasing risk.

 

“People move from senior-secured debt to unsecured. They buy 10yr Italian telecom debt instead of 5yr. This time, the rise in system-wide risk is not explicit leverage, it is implicit leverage.”

 

“Companies are leveraging themselves this cycle,” explained the same investor, marveling at the scale of bond issuance to fund stock buybacks.

 

“When people buy the stock of a company that is highly geared, they have more risk.” It is inescapable.

 

“It is not so much that a few sectors are insanely overvalued or explicitly overleveraged this time, it is that everything is overvalued and implicitly overleveraged,” he said.

 

“And what people struggle to see is that this time it will be a financial accident with economic consequences, not the other way around.”

This Michigan Bank Just Brought Back The Zero-Down Mortgage; They"ll Even Cover Your Closing Costs

A small savings bank in Michigan, Flagstar Bank, has come up with a genius, innovative new mortgage product that they believe is going to be great for their investors and low-income housing buyers: the "zero-down mortgage."  What"s better, Flagstar is even offering to pay the closing costs of their low-income future mortgage debtors.  Here"s more from HousingWire:

Under the program, Flagstar will gift the required 3% down payment to the borrower, plus up to $3,500 to be used for closing costs.

 

According to the bank, there is no obligation for borrowers who qualify to repay the down payment gift.

 

The program is available to only certain low- to moderate-income borrowers and borrowers in low- to moderate-income areas throughout Michigan.

 

Borrowers would not have to repay the down payment or closing costs. But a 1099 form to report the income would be issued to the Internal Revenue Service by the bank. So the gifts could be taxable, depending on the borrower’s financial picture.

 

Flagstar said borrowers who might qualify for its new program typically would have an annual income in the range of $35,000 to $62,000. The sales price of the home -- which must be in qualifying areas -- would tend to be in the range of $80,000 to $175,000.

Think it"s too good to be true?  Lakeshia Wiley of Detroit"s west side begs to differ...she recently went through Flagstar to purchase her new home and only had to come up with $350 of her own money.  Per the Detroit Free Press:

Lakeshia Wiley, 35, said she wouldn"t have been able to buy her first home without the Fifth Third Down Payment Assistance program and two other grants, including one from Southwest Solutions.

 

The brick home, built in 1951, is on Detroit"s west side, needed very little work and was priced at $50,000.

 

"I"m very excited every time I think about it. It"s beautiful. I love it," Wiley said.

 

Wiley never expected to be able to buy a home, though, because she has had a hard time saving for a down payment.

 

"I didn"t think I"d be able to do it," said the single mother who has two sons, ages 17 and 10, and a daughter, age 6. She works at a Detroit pharmacy.

 

Thanks to the down payment assistance and the grants, Wiley was able to buy her home in April. She had to bring less than $350 to the table at closing.

The Flagstar program is available in 18 counties in Michigan, and could be used for certain homes in Detroit and Flint, along with other cities.

Of course, we would highly encourage Flagstar to take a look back into ancient history for case studies on what happened the last time banks started peddling "innovative" mortgage products.  Here"s a summary of the Lehman Brothers case study:

Ironically, South Park also did some fascinating research on the topic:

Einhorn: "None Of The Problems From The Financial Crisis Have Been Solved"

A month ago, a downbeat David Einhorn exclaimed "will this market cycle never turn?"

Despite solid Q3 performance, Einhorn admitted that "the market remains very challenging for value investing strategies, as growth stocks have continued to outperform value stocks. The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy. The knee-jerk instinct is to respond that when a proven strategy is so exceedingly out of favor that its viability is questioned, the cycle must be about to turn around. Unfortunately, we lack such clarity. After years of running into the wind, we are left with no sense stronger than, "it will turn when it turns"."

Such an open-ended answer, however, is a problem for a fund which famously opened a basket of "internet shorts" several years prior, and which have continued to rip ever higher, detracting from Greenlight"s overall performance.

This, in turn, has prompted Einhorn to consider the unthinkable alternative: "Might the cycle never turn?" In other words, is the market now permanently broken.

While the Greenlight founder did not explicitly answer the question, in a speech yesterday at The Oxford Union in England, Einhorn made it extremely clear just how farcical he believes this market, and world, has become, pointing out that the problems that caused the global financial crisis a decade ago still haven’t been resolved.

“Have we learned our lesson? It depends what the lesson was,” Einhorn, the co-founder of New York-based Greenlight Capital, said at the Oxford Union in England on Wednesday.

Infamous for his value investing style and bet against Lehman Brothers that paid off in the crisis, Bloomberg reports that Einhorn said he identified several issues at the time of the crisis, including the fact that institutions that could have gone under were deemed too big to fail.

The scarcity of major credit-rating agencies was and remains a factor, Einhorn said, while problems in the derivatives market “could have been dealt with differently," and in the “so-called structured-credit market, risk was transferred, but not really being transferred, and not properly valued.”

“If you took all of the obvious problems from the financial crisis, we kind of solved none of them,” Einhorn said to a packed room at Oxford University’s 194-year-old debating society.

 

Instead, the world “went the bailout route.”

 

“We sweep as much under the rug as we can and move on as quickly as we can,” he said.

Einhorn didn’t avoid discussing his underperformance, citing several failed bets that companies’ stocks would decline. He didn’t name the stocks he was shorting, but insisted that none of the companies are “viable businesses.”

Value investing has worked over time, but “it’s not working at all right now,” and in fact “the opposite seems to be working,” he said.

Greenlight remains focused on developed markets, and has no plans to change that, he said.

Which reminds us of his exasperated conclusions from the latest Greenlight letter to investors:

Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value. What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss?

 

It’s clear that a number of companies provide products and services to customers that come with a subsidy from equity holders. And yet, on a mark-to-market basis, the equity holders are doing just fine.

Ah yes, the Fed-funded "deflation trade" which lowers prices for goods and services courtesy of ravenous investors who will throw money at any "growth" idea, without considerations for return or profit, because - well - more such investors will emerge tomorrow.  After all, in this day and age of ZIRP, what else will they do with their money.

Here's How People Get Fooled Into Buying Bankrupt Companies...

Authored by Simon Black via SovereignMan.com,

In 1906, American entrepreneur William T. Grant opened his very first “W.T. Grant Co 25 cent store” in a small town outside of Boston.

The store became popular and fairly profitable. So Grant opened another. And another.

Three decades later, Grant’s retail empire was generating $100 million in sales (an enormous sum back then). And by the time of Grant’s death in 1972, there were over 1,000 stores bearing his name.

Investors loved W.T. Grant Company stock for its reliable profits and high dividends.

Many of our subscribers may remember W.T. Grant. The chain was among the largest in the US at its peak.

And then something completely unexpected happened…

In 1976, W.T. Grant Company declared bankruptcy.

At the time, it was the second biggest bankruptcy in US history. And, like the downfall of Lehman Brothers and other big Wall Street institutions at the onset of the 2008 financial crisis, it was a shock to the world.

How could a company as big and profitable as W.T. Grant Co. go bust?

In the autopsy that followed the bankruptcy, accountants found that while the company was generating substantial PROFIT, it was not generating any CASH FLOW.

These two terms sound the same, but they’re dramatically different.

Profit, or more specifically net income, includes all sorts of bizarre accounting rules that don’t actually make sense in the real world.

Due to these rules, companies are often required to adjust revenue and expenses for things like “depreciation”, or “foreign exchange gains and losses”.

These are all merely accounting terms that don’t directly and immediately affect cash balances. But they can dramatically impact “profitability.”

Here’s one example from my own experience: a few years ago, the large agriculture company that I founded here in Chile purchased a farm.

We bought it for far below the property’s market value.

It was a great deal for the business. BUT… accounting rules required that our company record a PROFIT based on the difference between what we paid for the property and what it was worth.

This idiotic rule made it seem like we achieved a profit simply for buying a property.

This makes no sense. In the real world, we would only earn a profit by SELLING the property for a higher amount than we paid. You can’t profit before you sell something.

It’s rules like this that make profit an unreliable metric.

CASH FLOW is much more accurate.

Specifically, OPERATING CASH FLOW tells us how much money a company makes from its business.

It strips out all the silly rules and focuses purely on how much cash a business generates from its operations.

Then there’s FREE CASH FLOW, which is the amount of money left over for investors AFTER a company makes all of the necessary investments it requires for future growth.

Cash flow is what counts. If a company has negative cash flow, it will eventually go under.

Profit can be misleading. And that’s what happened to W.T Grant Co. It was profitable but had negative cash flow.

Today there’s another famous business in similar circumstances– our old friend Netflix.

Quarter after quarter, Netflix reports a profit.

Just yesterday afternoon the company had its quarterly earnings call, posting a profit of $553 million. Not bad.

Yet when anyone dives just a little bit deeper into the numbers, Netflix’s cash flow is absolutely gruesome.

The company’s operating cash flow is negative. In other words, after stripping out all the unrealistic accounting nonsense, Netflix’s core business LOSES MONEY.

In fact Netflix’s operating cash flow has been negative FOR YEARS. And the amount of money its losing is increasing.

Netflix’s business has lost $1.3 billion so far through the first nine months of 2017. That’s 52% worse than the $916 million operating cash flow deficit they suffered in the first nine months of 2016, and nearly three times worse than the $504 million operating cash flow deficit during the first nine months of 2015.

Throughout this period, the number of Netflix subscribers has steadily grown, now well in excess of 100 million.

And every time Netflix reports a big surge in subscribers, the stock price soars.

This is truly bizarre. Just look at the cash flow numbers: as the number of Netflix subscribers has grown over the years, the company losses have grown even more.

It reminds me of that old saying from the 1990s dot-com bubble– “We lose money on every sale, but make up for it in volume.”

But it gets worse.

The company’s negative operating cash flow doesn’t include the billions of dollars that it spends on content.

And on its quarterly earnings call yesterday, executives announced they will spend a whopping $8 billion on original content next year.

That’s $8 billion that they don’t have. And don’t forget the $1.4 billion operating cash flow deficit.

Where are they possibly going to find this money? Simple. Debt. Netflix will pile on more and more debt despite racking up enormous cash flow deficits.

Now, to be fair, it’s not unusual for a business to lose money for a period of time as part of a longer-term plan to generate strong cash flow.

But just look at this industry: it seems like EVERYONE is diving in to this original content game.

Apple. Facebook. Amazon. CBS. Disney. Google. Sony. Time Warner. Hulu. Each of these organizations has developed a streaming service with original content.

And some of them (especially Google and Facebook) have an endless war chest thanks to their cash-gushing core businesses.

Google’s parent company (Alphabet) reported free cash flow of $11.6 billion in the second quarter alone. So it could easily outspend Netflix and still have billions of dollars left over.

All of this competition is going to be great for consumers; these companies are collectively spending tens of billions of dollars to entertain us. And they’re going to lose money doing it.

But for investors this is sheer madness. Don’t be the sucker paying for other people’s entertainment.

And to continue learning how to safely grow your wealth, I encourage you to download our free Perfect Plan B Guide.

Original 'Dr. Doom' Says Next Fed Chair Must Break Up Banks "To Be Small Enough To Fail"

Henry Kaufman, the former chief economist of Salomon Brothers in the 70"s and 80"s who earned the moniker of "Dr. Doom" for his frequent criticisms of the Fed"s interest rate policies, has some advice for President Trump on how to pick the next Fed Chair: find someone willing to break up the "too big to fail" banks.

“You’ve got to be small enough to fail” without that failure causing problems that cascade through the financial system, Kaufman said in the question-and-answer session of an Economic Club of New York breakfast on Oct. 5 at the imposing University Club on Fifth Avenue. As it is now, Kaufman said, “We are trying to preserve conglomeration.”

 It’s more important for the next Fed chief to have a good understanding of how markets work than it is to own a Ph.D. in economics or to have been a business titan, Kaufman said.

William McChesney Martin, who ran the Fed from 1951 to 1970, never earned a graduate degree in economics. But he “turned in a good performance” in overseeing a period of healthy economic growth, Kaufman said. In contrast, he said, the two Fed chiefs who followed Martin allowed high inflation to become embedded in the U.S. economy in the 1970s. The first, Arthur Burns, was a distinguished Ph.D. economist from Columbia University. The second, G. William Miller, came to the Fed from Textron Inc., where he was chief executive officer.

Of course, even though Kaufman is credited with accurately calling the market bottom on August 17, 1982, he has proven on several occasions that he doesn’t quite always get things right.  He invested some of his personal wealth with Bernie Madoff, which ultimately turned out to be one of the biggest ponzi schemes in American history, and was the chairman of the Lehman board"s finance and risk committee before the bank collapsed into bankruptcy in 2008...not a great track record of late.

That said, Kaufman seems to have learned from those mistakes after leaving the Economic Club of New York with the following uplifting thought: "There will be another financial crisis. And it will pop out. And we’ll all say, ‘How did it happen?’”

Stock Market Bubbles In Perspective (Or Why "This Won't End Well")

Authored by Howard Ma via Meritocracy Capital,

Last week marked the 9th anniversary of the collapse of Lehman Brothers. It was one of the biggest milestones of the Global Financial Crisis (“GFC”) that began approximately a year earlier in 2007. Corporate earnings were abnormally weak during the GFC. I bring that up because a much cited stock market valuation metric that has been prescient gauging past bubbles could be overstated due to those abnormally weak earnings. Those of you concerned about the valuation of the U.S. stock market should read on.

What Does Average Mean?

The cyclically-adjusted price-to-earnings (“CAPE”) ratio is normally credited to Nobel-prize winning economist Robert J. Shiller. It adjusts for the ups and downs of business cycles by comparing the price of the S&P Composite Index to the average, annual inflation-adjusted earnings of that index over the previous 10 years. There are three types of averages: mean, median and mode. The type of average the CAPE ratio uses is the mean (a.k.a. arithmetic mean). Though the CAPE ratio has been shown to be a reliable predictor of future long-term stock market returns, it has also been widely criticized.

One criticism is that the CAPE ratio is susceptible to outliers. For example, those abnormally weak earnings that occurred during the GFC drag the mean, annual inflation-adjusted earnings down. This could make the CAPE ratio of the S&P Composite Index look more expensive than it may actually be. It has been widely reported that the CAPE ratio is currently at a very high level behind only two other stock market peaks: 1) the Tech Bubble, and 2) the stock market bubble that occurred during the Roaring Twenties (immediately preceding the Great Depression). In both cases, the stock market eventually crashed and in spectacular fashion.

One way to adjust for this problem of abnormally weak earnings is to instead use the peak earnings of the past decade. This approach has been credited to investment manager John Hussman. Ironically, the lesser known Hussman P/E currently shows that the S&P Composite Index is at a very expensive level second to only the Tech Bubble. Those who argue the U.S. stock market is not expensive don’t care for this approach.

Using a Better Average

I agree that using an arithmetic mean makes the CAPE susceptible to outliers. I also agree the CAPE ratio can also make the valuation of the S&P Composite (or any stock market index) look more expensive than it may actually be. Though I believe the Hussman P/E is useful, I don’t believe it is a substitute to the CAPE ratio. An average measures a central or typical value. Using a peak figure, as in the case of the Hussman P/E, does not do this. By using peak earnings, the Hussman P/E is in fact driven by outliers.

Mentioned earlier, there are three types of averages. A better type of average would be the median. It literally represents the middle of a sequence of ranked numbers. In most cases, it is not influenced by outliers. By using median (instead of mean) earnings, I refer to this valuation approach as the CAPME ratio. It currently shows the S&P Composite is not the second or third most expensive stock market cycle. This finding supports those who criticize the traditional CAPE ratio of overstating the valuation of the S&P Composite Index. The problem for critics though is using the CAPME ratio still shows the U.S. stock market is very expensive right now. In fact, it is the fourth most expensive, behind the stock market cycle that occurred during the Subprime Mortgage Bubble. Based on the data Professor Shiller uses, you can see this in the graph below that looks back 135 years.

Valuations in Perspective

You will notice in the graph above that the past 5 stock market bubbles were all valued at one point at more than 20-times median, annual, inflation-adjusted earnings. The valuation range of those peaks is wide though given the Tech Bubble was valued at more than 40-times at its peak.  This makes the Tech Bubble potentially an outlier. Furthermore, all 5 stock market bubbles did not last long. They were fleeting.

To put this all into perspective, consider these valuations by their percentile ranks. You can see this from the orange lines in the graph below.

The graph above shows the aforementioned 5 stock market cycles turned into bubbles when their CAPME valuation ratios reached a very high level of roughly the 90^th percentile (red dotted line). In other words, these bubbles formed when their valuations were near or at the most expensive decile. Investors beware: the valuation of the S&P Composite Index is currently ranked at the 94^th percentile.

This puts the U.S. stock market smack-dab at the heart of bubble territory.

It has been argued lots that the high stock market valuation is justified by low interest rates. This argument does not work for me. Let me tell you why. Yields on 10-year U.S. treasury bonds in early-1941 were lower than they are now. Despite lower interest rates in early-1941, the stock market CAPME valuation ratio was quite low at that time ranking at around the 30^th percentile. Furthermore, the amount of debt provided by stock brokers used to fuel the current stock market cycle is at a record level. This could prove problematic given bubbles driven by financial leverage are particularly dangerous.

Summary

The aforementioned 5 stock market cycles turned into bubbles when their CAPME valuation ratios reached the 90th percentile. The U.S. stock market is back there again. Its valuation is squarely in the middle of that very expensive decile looking back 135 years.

The 5 previous instances of stock market bubbles suggest this will not end well. Bubbles never do, particularly ones driven by financial leverage.

For The First Time Since January 2016, The Market Volatility Regime Finally Snapped

• August 17 marked the first time since January 16 when global equity, rates, commodity and FX vols all moved in the same direction. 


• At the same time, short-dated cross asset correlation continued to rise reaching a level of 50%, its highest level in over 1y.

For months on end, traders, analysts and pundits have been pointing to record low implied vol as a sign of pervasive complacency (and in some cases, "trader paralysis") in response to a market that made no sense, and where the only permitted direction was "up." That may finally be ending, and not just based on references to seasonal patterns that have zero relevance in a "new normal" driven by central bank asset purchases, but because the market"s artificial sense of calm is finally starting to crack, as observed by the recent surge in 20-day S&P realized vol.

And when realized vol starts rising, implied vol promptly follows, and when implied vol rises, it creates a feedback loops in which vol sellers are forced to cover, raising realized vol even more, pushing implied vol higher, and so on, as the current cycle of unprecedented volatility selling eventually ends, with either a bang or a whimper (spoiler alert: the former).

Meanwhile, as both volatility metrics rise, cross-asset volatility - traditionally an indicator of latent market stress - follows. And in what may come as a surprise to some, while most have been lamenting the blanket of broad market complacency in the past year, which in recent months have been validated by near record low global cross-asset implied volatilities....

... Bank of America points out that short-dated cross asset correlation has been rising over the past few months and currently stands at 50%, its highest level in over a year. Meanwhile, the correlation of cross asset vols may have also reached a turning point: August has been the first month in over a year to witness a simultaneous rise in global equity, rates, commodity and FX volatility. In fact, August 2017 marked the first month since January 2016 in which all cross asset risk measures rose modestly over the month, even if they still remain in significantly benign territory.

To BofA"s derivatives strategist Benjamin Bowler, this suggests that various pockets of the market are finally beginning to agree on the presence of risk, albeit to varying extents.

More ominously, on a consolidated basis as noted above, in August short-dated (3-month) cross asset correlation continued to rise reaching a level of 50%, its highest level in over a year. Historically there have been 3 distinct cross asset correlation regimes since 1995.

Interestingly, the broad upward trend started in Oct-03, well before the Lehman bankruptcy in Sep-08. This is related to the liquidity driven crush in asset risk-premia that helped drive investment leverage higher. Long-term correlation established a new regime starting some time in 3Q13, similar to the ’03 to ‘08 correlation environment. With the recent surge in cross-asset vol, that regime may now be ending too.

The good news, as BofA also points out, is that the uptick in volatility and credit spreads in most cases was modest in magnitude, leaving global cross asset risk metrics well within benign territory amid a backdrop of rising geopolitical tensions on the Korean peninsula. This means that it is still historically cheap to purchase efficient hedges ahead of what is already proving to be a catalyst-rich fall.

As a final observation, BofA then lays out the cheapest derivatives across the entire global derivatives universe, in other words, those which have the highest upside in case of a crash.

The chart below shows crash returns of different assets during historical tail events per unit of current OTM option implied volatility. Ranked by the average, the screen shows that the hedges which are most underpricing historical drawdowns are: US & EU IG credit payers, Gold calls and RDXUSD (Russian equity) puts: US & European IG credit payers still rank as the best value hedges across all assets in our universe followed by Gold (and Gold ETF) calls. In equities, RDXUSD (Russia), NIFTY (India) and TWSE (Taiwan) puts screen as top hedges while puts on NASDAQ (US Tech), Top40 (S. Africa) and ASX200 (Australia) rank as the most expensive.

Finally, those who want to hedge against a crash may want to avoid buying USDJPY puts: USDJPY puts once again are at the very bottom of BofA"s screen (most expensive tail hedge) as the ongoing geopolitical risk flare on the Korean peninsula has likely increased demand for JPY as a risk-off asset. In contrast, Nikkei puts, while belonging to the same region, currently rank as the cheapest DM equity hedge.

Hedge Fund CIO: "Want To Make A Grown Nerd Cry? Run A 500% Rate Increase Through His Risk Model"

August is over, which means that Eric Peters, the CIO of One River Asset Management, is back to doing what he is so very good at: distilling the week"s events and latest financial and economic trends into pithy, one-paragraph aphorisms.  Without further ado, here is an anecdotal excerpt from his latest weekend notes.

* * *

Scary Movie

I love movies. Scary ones especially. Keep your happy endings, give me chainsaws. Meat hooks.

I’ll never forget ERM in 1992. That was my first real snuff flick as a Lehman prop trader. The Italians never stood a chance in the film, they never do. Show me an Italian who can resist a dark woodshed and I’ll show you a hero in a hockey mask.

At least the Swedes put up a fight in the flick. Their central bankers raised overnight rates to 500%. Want to make a grown nerd cry? Run that interest rate through his risk model. But of course, not a single propeller-head imagined such a monster.

Anyhow, my next scary movie was Orange County, 1994. The great bond massacre brought terrified traders to tears.

Mexico devalued too; Tequila Slammer. So many strings inextricably woven into that tangled tale.

These intricate plots build over years, unravel in months. Asian Flu was released in 1997, classic zombie apocalypse genre. Just when the virus seemed contained, along came a sequel; Russian Flu in 1998. A month later they released LTCM, a documentary about the dangers of mixing academics and money.

Wall Street is remaking that classic as we speak; a big budget Black Monday II. Revenge of the Sock Puppet was released in 2001, followed quickly by 9-11.

Then things went quiet for what seemed like forever. But 7yrs later Haunted House came out - scared the crap out of everyone, even hardened criminals flipping cribs from cellblocks.

European Debt Crisis was released in 2011, a real nail biter, until some Italian saved mankind with a printing press. It’s been happy endings ever since.

Chick flicks, corsets, period pieces. Utterly boring. But in my three decades of watching scary movies, on average there’s been a blockbuster surprise every three to four years. And it’s been six since 2011.

Talking Global Macro Investing With A 25-Year Market Veteran

By Chris at www.CapitalistExploits.at

If you were rich, successful, and intelligent - which often, not always, go hand in hand together - where would you live?

The last time I was in the Rockies, I remember thinking to myself. You know what, if it weren"t for the fact it"s so damn far from the beach I could actually live here. It"s really quite lovely. Bite-your-hand-to-stop-you-from-crying-out-loud-lovely and if, like me, you"re a sucker for snowboarding, then it"s pretty hard to be disappointed.

After having just spent a few days of pure bliss (uninterrupted sunshine with zero wind) skiing on this baby in New Zealand, I can certainly appreciate living in Vail.

Maybe that"s why Julian Brigden, the co-founder of Macro Intelligence 2 Partners, lives there. I"ve never asked him about it, but I did ask him a bunch of other questions which I share with you today.

The quick and dirty on Julian"s background:

He"s accumulated 25 years of experience in financial markets. From 1999 to 2004, he was with Medley Global Advisors, a macro policy intelligence firm. Then from 2004 through 2011, Julian served as North American Head of Hedge Fund Sales at Crédit Agricole.

He has worked in London, Zurich, New York, and Vail at UBS, Lehman Brothers, HSBC, Drexel, Credit Suisse, and Salomon Brother in foreign exchange and precious metals.

If you"ve not heard of Julian, he"s easily searched with some stubby fingers and Google as he"s been featured on Bloomberg, CNBC, the New York Times, Wall Street Journal, and in Barron’s among other for the firm"s research on emerging markets, liquidity, QE, bubbles, and global FX flows.

As you can see, Julian"s far from some dolt-peddling advice.

In our recent conversation, we chatted about a number of things:

• The state of the global bond market


• Julian"s views on the US dollar


• What happens when central bankers get what they wanted (case study: Europe)


• Demographics and Japan


• And a host of other things which came up in conversation

I hope you enjoy it!

- Chris

“When the second wave comes in terms of the stimulus package from Trump and in particular the corporate tax repatriation, the sucking sound from the rest of the world, as the dollars come home, will mark the ‘risk off’ phase and it’s possible that you push the dollar so far that its status ultimately as the reserve currency will end up being challenged." — Julian Brigden

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Liked this article? Then you"ll probably like my other missives on

this topic as well. Go here to access them (free, of course).

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Debt Ceiling Deal Doubts Rise - USA Default Risk Hasn't Done This Since Lehman

The US Treasury Bill market remains notably inverted around the uncertain timing of the US debt limit debacle.

As Bloomberg reports, while Treasury bills maturing in October continue underperforming against November and December securities, the market has a murky view on the drop-dead date for the U.S. debt ceiling.

At the start of last week, concerns shifted to early October after the Treasury said in its 3Q refunding statement that it expects to be able to fund the govt through the end of September.

Focus then shifted back toward mid-October after the head of the House Freedom Caucus said he is ready to accept a debt ceiling increase without other conditions

However, one more worrisome market is starting to notably wake up to the reality of a deeply divided congress unable to agree on anything. The market for sovereign credit risk is flashing red with USA 5Y CDS now trading at its most extreme levels to German 5Y CDS since Lehman.

Note that the current credit-risk-premium for US Treasuries is higher than it was during 2013"s government shutdown and 2015"s down-to-the-wire debt ceiling debate.

But while Treasury and credit markets are flashing red anxiety levels, the VIX curve is doing the exact opposite and pricing in a relative drop in volatility... before a resurgence in the start of 2018...

So T-Bills worry about early October... VIX worries about year-end... and CDS confirm they have a problem. Who will be right?

"Visions Of Cataclysms": Why Eric Peters Is Starting A Long-Vol Fund

Is the recent streak of record low volatility about to end?

While countless analysts, pundits and traders have previously talked their book (if not staked their reputation) on claims VIX is set for an imminent mean-reverting spike, so far that has not happened and in fact net spec positioning in the VIX just hit a record short print as of the latest CFTC week.

And yet, on Friday night, in a notable change to the low-vol regime, Interactive Brokers announced it would hike volatility product margins ahead of what it warned could be a 100% surge in the VIX, a move which will be promptly copied by most if not all trading platforms. Will this then become a self-fulfilling prophecy - should maringed out traders decide it makes more sense to close out vol shorts than to add more cash - it is too early to know, however, in a separate confirmation that the current low-vol regime may be ending, last week JPM"s quant strategy team reported that "following robust performance in 1H ‘17, PnL of short vol premia stagnated over the past month... We see further risk for short vol from both rate increase as well as CB balance sheet renormalization."

YTD, short vol PnL (+5.1%) exceeds that of traditional beta (+4.2%) and value (+4.1%). Momentum YTD PnL of -5.2% arose from a broad-based decline across global equity indices (-5.1%), sovereign bonds (-2.1%), currencies (-1.4%) and commodities (-12.0%). Carry was flat (+0.9% YTD) as it was buffeted by positive bond carry (+3.9%) and negative equity index carry (-1.6%). Over the past month, short vol has stagnated at 0.26% and momentum has continued its decline by - 0.71%.

And with no further P&L to be made from selling vole, the question again emerges: is the vol-selling party coming to an end?

To answer that question today in abstract terms, we give the podium to our favorite Sunday morning commentator, One River Asset Management"s CIO Eric Peters, who today in lieu of his traditional weekend notes, has penned a piece titled: "The Case for Long Volatility" in which he explains that a surge in volatility is inevitable for one simple reason: human imaginations will soon run rampant with visions of cataclysms... something which that other derivatives guru, DB"s Aleksandar Kocic also said precisely two months ago, when he predicted that the "Market"s Current "Metastability" Will Lead To "Cataclysmic Events."

Some of the key excerpts from Peters" note:

To sell implied volatility at current levels, investors must imagine tomorrow will be virtually identical to today. They must imagine that bond yields won’t rise despite every major central bank looking to hike interest rates and exit QE. They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by decelerating global growth. And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure. I can imagine a few of those things happening, but neither sustainably nor simultaneously. It is much easier to imagine a tomorrow that looks different from today.

Zero interest rates and quantitative easing left yield-starved investors with few ways to achieve their target returns. Wall Street’s engineers developed many wonderful solutions to this problem. Their magnificence is matched only by the amount of negative convexity now lurking in investment portfolios.

As volatility declined, investors have had to sell even more of it to sustain sufficient profits. This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices. This in turn reduces volatility, reflexively. Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, I can imagine a historic reversal.

And at that point, investor imaginations will run rampant with visions of cataclysms. It is always thus, it is who we are. Confidence in a tomorrow that is indistinguishable from today will vanish, replaced by some new hysteria. It could be real or imagined. It could even be a bullish blow-off mania like 1999. Or maybe an endogenous crash, like 1987, when market moves were disconnected from the real economy. But the catalyst doesn’t really matter. What matters is recognizing that at this late stage, with implied volatility where it is, and asset valuations where they are, if you can imagine a tomorrow even modestly different from today, you must begin finding thoughtful ways to get long volatility.

Peters has imagined precisely that, and as a result, the CIO writes that he sees a "compelling opportunity developing in the months ahead" to go long volatility, and is launching a fund to capture it.

* * *

His full note below (link):

The Case For Long Volatility

I have an active imagination. A blessing and curse. I’m not alone. Of our many defining features, imagination is the greatest single thing separating us from other creatures. There is no higher power. Our ability to conceive of a tomorrow that is better than today is a precondition to discovery, invention. And these two things quite naturally stack, compound. Their summation has lifted us from the Stone Age to the space station. The journey has only just begun. This should be obvious to everyone but the most hopeless pessimist.

Along our upward trajectory are periodic interruptions. Some are natural, such as plagues. Others are economic, particularly depressions. But most are political, and the greatest arise when nations imagine future states of the world that are different and incompatible. These ideological conflicts can be devastating, lasting for years as hot or cold wars, but even so, they have barely restrained our rise. The motive force of humanity’s imagination, ambition, and drive to build better lives for our children is such that nothing has suppressed progress for long.

Economically speaking, our ascent is defined by rising productivity, the spoils of which determine prosperity. In modern times, we have imagined various ways to distribute this wealth; socialism, communism, free-market capitalism. I can imagine other approaches; the Chinese are exploring one. But even within existing constructs, there are nuances. Today in the West, capital owners collect a disproportionate share of profits relative to laborers. There is no intrinsic reason that this degree of inequality cannot persist. But in modern history it never has.

The private sector overwhelmingly sees itself as a more capable steward of research and development capital than governments. However, an examination of innovations traceable to state-funded initiatives during the past century suggests otherwise. I suspect the failure of Soviet communism led western free-market capitalists to imagine every element of our system to be superior. I imagine someday we will regard that black and white conclusion as foolish. China’s unprecedented economic rise and breathtaking technological advances should prompt Western self-reflection. So far it has not. I can imagine this being forced upon us.

In fact, I can imagine many things. I can imagine almost everything, except of course, things that never cross my mind. Those are unknown unknowns, Black Swans. In my lifetime, not a single such creature has reversed human progress, let alone markets. Not for long anyway. Lehman was not a Black Swan. I worked there for seven years and we spent most of them imagining the firm abruptly failing. Black Swans are generally magnificent, indistinguishable from magic - the internet, smartphones, cloud computing, quantum entanglement. The big risks are skewed to the upside, and manifest frequently. That is why we no longer live in caves. Yet periodically, our imaginations run wild with visions of cataclysms. I imagine that will never change.

In theory, investors compound savings at a rate commensurate with the upward slope of human progress. But people can pay anything they choose for assets and their derivatives. They periodically earn higher returns than that slope would indicate by bidding up prices far in advance of actual growth. However, they cannot do so forever without the gap between today’s reality and tomorrow’s promise becoming a chasm, prone to collapse. That said, almost any price can be justified if the slope of progress steepens, and every so often, something new appears that allows investors to imagine it will. But in modern history it never really has.

This leads me to investing. Which is principally about medium to long-term trend following. To obsess over much shorter time horizons is to imagine you can consistently outsmart people who imagine themselves smarter than you. A quick check on the number of billionaires who made their fortunes imagining such nonsense will tell you all you need to know on that topic. Anyhow, trend following is theoretically easy; over the long-term conditions improve. But because we base asset prices partly on their future value, and as every solvent investor imagines that trajectory to be upward, prices are almost always elevated relative to today’s reality - and thus prone to corrections. So trend following is easier said than done, and can be improved upon by periodic tactical adjustments, hedges.

With that in mind, it is hard to overstate the extraordinary nature of today’s landscape. All previous periods of extreme asset valuation required investors to imagine a vastly different tomorrow, a wildly optimistic future, a steeper slope. But today they expect the opposite. Due to unfavorable demographics and over-indebtedness, investors expect the slope to flatten, perhaps forever. Yet because of this flattening, they also imagine perpetually low interest rates, which they then use to justify extreme valuations across other asset classes in an endogenous loop that is increasingly disconnected from the real economy. This is the dominant pricing model for global assets today. I can imagine it continuing for a while still, but not in perpetuity.

Implied volatility is the price that connects two sets of people; those seeking to offload risks and those prepared to shoulder them. When imaginations are running wild, implied volatility is high, reflecting disagreement and uncertainty about what those risks are, and/or how they will resolve themselves. Low implied volatility reflects just the opposite. We are now at historic lows.

To sell implied volatility at current levels, investors must imagine tomorrow will be virtually identical to today. They must imagine that bond yields won’t rise despite every major central bank looking to hike interest rates and exit QE. They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by decelerating global growth. And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure. I can imagine a few of those things happening, but neither sustainably nor simultaneously. It is much easier to imagine a tomorrow that looks different from today.

Investment banks and asset managers devise creative strategies to make money once valuations exceed reasonable levels. These perpetual prosperity machines typically combine leverage and alchemy, transforming real risk into perceived safety. Examples abound. But in this cycle, a proliferation of cleverly disguised volatility-selling strategies has dominated. Zero interest rates and quantitative easing left yield-starved investors with few ways to achieve their target returns. Wall Street’s engineers developed many wonderful solutions to this problem. Their magnificence is matched only by the amount of negative convexity now lurking in investment portfolios.

As volatility declined, investors have had to sell even more of it to sustain sufficient profits. This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices. This in turn reduces volatility, reflexively. Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, I can imagine a historic reversal.

And at that point, investor imaginations will run rampant with visions of cataclysms. It is always thus, it is who we are. Confidence in a tomorrow that is indistinguishable from today will vanish, replaced by some new hysteria. It could be real or imagined. It could even be a bullish blow-off mania like 1999. Or maybe an endogenous crash, like 1987, when market moves were disconnected from the real economy. But the catalyst doesn’t really matter. What matters is recognizing that at this late stage, with implied volatility where it is, and asset valuations where they are, if you can imagine a tomorrow even modestly different from today, you must begin finding thoughtful ways to get long volatility.

And just like that, the "fat tails" funds are back.

Hong Kong Interbank Rates Spike To Highest Since Lehman

For only the third time since Lehman, the price of liquidity in the Hong Kong Dollar interbank markets has exploded higher.

Overnight HKD Hibor soared over 60 basis points to 0.71407% in Monday trading - the highest since October 2008...

Note that the two previous spikes were around year-end, so this is unusual in both its velocity and size.

Of course, the narrative of a panic in Asian liquidity is not a good one for supporting risk assets and so the spike is being dismissed as a one-off due to several factors (as Bloomberg reports)...

Monday’s rise in Hong Kong dollar overnight interbank rate was due to major fund providers being more cautious in lending at month-end, and because of demand from some market players, a Hong Kong Monetary Authority spokesperson writes in an emailed reply to questions from Bloomberg. Interest rates subsided when fund providers responded by lending out more Hong Kong dollars. Relatively large movements in short- dated interest rate Monday was probably a result of thin market conditions ahead of the month-end. The market continued to function normally.

Monday’s sudden spike in HKD overnight funding cost is probably due to short-term funding activities, likely for I Squared Capital’s purchase of Hutchison Telecom’s unit and HSBC share buyback announcement, says Angus To, deputy head of research at ICBC International Research.

Rate likely to drop soon as HKD liquidity remains ample in general, To says in a phone call.

So just ignore the fact that the HKD liquidty markets just exploded due to month-end (well it hasn"t before - see chart) and some M&A (there"s been no M&A in the last 9 years?)... it"s probably nothing.

JPM: "Investors Are Starting To Hedge Against A Crash"

It"s probably not a coincidence that in the same week in which one of the most level-headed investors of all, Oaktree"s Howard Marks issued an alarm on the current state of the market, that JPM has come out with not one (as discussed previously, Marko Kolanovic"s latest "tipping point" note last Thursday was blamed for the small and sharp selloff at the end of last week), but two reports in which JPMorgan makes it clear that not only is the market on the edge, but increasingly more traders, both institutional and equity, are getting ready for what comes next.

First, as another reminder, these are the 4 bullet points with which Marks summarized the current investing environment:

• The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.


• In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.


• Asset prices are high across the board.  Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.


• Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.

One day later, Kolanovic added fuel to the fire, warning that with volatility at record lows, the upcoming mean-reversion will leave many in ruin, and that while there is still time to get out of the market, "we may be very close to the turning point":

"In what is akin to the law of ‘communicating vessels,’ once inflows in bonds stop, funds are likely to start leaving other risky assets as well, including equities. The FOMC statement yesterday alleviated immediate fears – normalization of balance sheet will start ‘relatively soon,’ but only if ‘the economy evolves broadly as anticipated.’ This reasonably dovish stance pushes this market risk out for a few weeks (the next ECB meeting is Sep 7th, Fed Sep 20th, BoJ Sep 21st). This gives volatility sellers and other levered investors a limited window to position for a seasonal pickup in volatility and central bank catalysts in September."

Not one to mince his words, the JPM head quant then compared the current period to the period just before 1987"s Black Monday, warning that "strategies that boost leverage when volatility declines, such as option hedging, CTAs and risk-parity, share similar features with the dynamic ‘portfolio insurance’ of 1987,” which “creates a ‘stop-loss order’ that gets larger in size and closer to the current market price as volatility gets lower.” Finally, from a timing standpoint, he said that as growth in short-vol strategies suppresses both implied and realized volatility, and with volatility at all-time lows “we may be very close to the turning point.”

* * *

Over the weekend, in yet another note from JPM, this time from the bank"s "flow" expert, Nikolaos Panigirtzoglou, he writes that none of the above should come as a surprise and that as a result, investors - both institutional  and retail - have started putting hedges against an equity crash.

Among the market feature he highlights is that the current put to call open interest ratio for S&P500 index options has been rising for most of this year, and that while this ratio had peaked in June and its current level is not extremely high, it nevertheless stands above its post 2014 average. What is more extreme, is the call to put open interest ratio for VIX options, which at almost 4.0, is close to historical highs.

To Nikolaos, the combination of these two observations implies that "there is greater demand for hedging against equity tail risk or a volatility spike relative to hedging against a typical equity market correction."

In other words, there is just the right amount of hedging for a crash.  And it"s not only institutional investors who are hedging. Retail investors have been also hedging.

Here are the details from Panagirtzoglou"s latest letter:

Our client conversations over the past few weeks have been dominated by the impending reduction of quantitative stimulus by the ECB and the Fed as the main risk markets are facing into the autumn. Our sense from these client conversations is that, as we approach September, the perceived likely timing of balance sheet shrinkage by the Fed and/or ECB tapering, investors have already started reducing their net exposure to risky markets via hedges in order to protect themselves against a repeat of the August 2015 correction. How consistent is this anecdotal evidence with our flow and position indicators?

One way of gauging institutional investors’ demand for hedges is by looking at the put to call open interest ratio for S&P500 index options, the biggest and most liquid listed index option market in the world. This put to call open interest ratio is shown in Figure 1. The ratio has been rising for most of this year. Although the ratio peaked in June and has declined somewhat since then, its current level remains above historical averages pointing to decent demand for hedging equity exposure. In fact, Figure 1 shows that since the oil price shock of 2014 the ratio has averaged at a higher level relative to previous years, i.e. there has been  structurally higher demand for hedging equity exposure since 2014 relative to previous years. The current put to call open interest ratio for S&P500 index options is not extremely high, but it stands still above the post 2014 historical average.

Another way of gauging institutional investors’ demand for hedges is by looking at the call to put open interest ratio of VIX options. The use of VIX options has risen exponentially since the Lehman crisis by investors seeking to hedge equity tail risk, credit exposure or volatility exposure. Several investor types such as vol targeting (equity or multi asset) funds or risk parity funds are structurally short volatility and we note VIX calls provide the most direct and liquid way to hedge their short volatility exposure.

This call to put open interest ratio for VIX options is shown in Figure 2. This ratio has been also rising for most of this year, especially over the past three months, as the collapse in equity index volatility to record low levels naturally induces demand for protection against a volatility spike. Typically, the open interest for VIX calls increases in low volatility periods as investors enter hedges, and declines after VIX spikes as investors unwind hedges. Similarly, the open interest for VIX puts increases in periods of high equity volatility as investors buy puts to sell equity volatility.

The main difference between Figure 2 and Figure 1 is that the call to put open interest ratio for VIX options stands at close to record high levels currently, while the put to call open interest ratio for S&P500 index options stands at just above its average since 2014. In other words, there is more extremity in the former implying greater demand for hedging against equity tail risk or a volatility spike relative to hedging against a typical equity market correction.

What about retail investors? Are they also boosting their hedges? We argued last week that the heavy buying of bond funds this year reflects, at least partly, the desire by retail investors to offset or hedge the rising AUM of their equity fund holdings. If this interpretation is correct then this year’s very strong bond fund buying is a reflection of strong demand for hedging by retail investors.

But retail investors are not only confined to buying bond funds for hedging. They also buy VIX ETFs, a universe which has also grown exponentially since the Lehman crisis along with VIX options. Retail investors continued to buy VIX ETFs this year albeit at a slower pace than last year. But their vol buying accelerated over the past month as the VIX index declined to record low levels. This is shown in Figure 3 which shows the cumulative flow into VIX ETFs vs. the flow into Inverse VIX ETFs.

And in Figure 4 which is provided by our Equity Derivatives Strategy team and which uses a more sophisticated calculation to estimate the net vega, i.e. sensitivity to each percentage point change in vol,

for the total universe of VIX related ETFs adjusted by their short interest. This vega stands at historical high levels currently.

Rising VIX ETF exposures are likely reflective of skepticism by retail investors, who are the main users of VIX ETFs, and who see the current combination of record low equity market volatility and record high equity  prices as rather unsustainable. Effectively, the collapse in both realized and implied volatility over the past months and the current record low level of the spot VIX index is inducing retail investors to buy VIX products on the expectation that volatility will increase. After all, uncertainty is high and the risk from central bank policy normalization seems significant. So establishing a long VIX exposure via ETFs at current levels appears on surface attractive as it implies a large potential upside, in the case that a negative shock, such as tapering or central bank balance sheet reduction, pushes the VIX up to much higher levels.

But this protection comes at a cost: as more money flows into long VIX ETFs, the VIX futures curve steepens making the negative roll more onerous and the cost of holding a VIX ETF for long rather prohibitive. As a result of the steepness in the VIX futures curve, popular VIX ETFs are currently losing close to 10% per month due to negative roll. If no negative shocks materialize over the coming months, it is likely that  negative-carry long-VIX positions are taken off, exerting downward pressure on the steepness of the VIX curve, from currently elevated levels.

3-Month Treasury-Bill Auction Prices At Highest Yield Since Lehman On Debt-Ceiling Concerns

It seems Morgan Stanley was right when they said "the debt ceiling worries us most," as today"s 3-month T-Bill auction surprised the market with its highest yield since the fall of 2008, as investors continue to price concerns that the U.S. government will exhaust its borrowing authority around mid-October.

As SMRA details:

The 3-month bill auction stopped at 1.180%, with a 67.70% allocation at the high yield. The 3-month auction bid/cover ratio was 2.87. The average 3-month bid/cover over the past three months was 3.13. The WI was last trading at 1.165% at 11:30 AM. Indirect bidders took down 38.44% of the 3-month bill auction and Direct bidders took down 5.61%.

The 6-month bill auction stopped at 1.130%, with a 34.87% allocation at the high yield. The 6-month auction bid/cover ratio was 2.91. The average 6-month bid/cover over the past three months was 3.30. The WI was last trading at 1.115% at 11:30AM. Indirect bidders took down 40.66% of the 6-month bill auction and Direct bidders took down 2.69%.

So the 3-month bill is priced 5bps cheaper than the 6-month bill and both dramatically tailed.

As BofA noted, the early pricing of debt limit concerns may reflect overhang from this week’s bill auctions and the "greater influence" of government money market funds following October"s reforms.

But, Morgan Stanley recently warned that the biggest immediate risk to the market is:

The debt ceiling worries us most, given that action may need to be taken within as little as seven weeks. But on the other issues, we’re more relaxed. The Senate’s Healthcare bill had an approval rating of 17%, so we doubt its failure would be a hit to consumer confidence. The Special Counsel’s investigation, whatever the outcome, will likely take considerable time. Our economic baseline was already cautious with regard to fiscal stimulus, a long-held view of our policy team. And while tax cuts could boost the market temporarily, they could also lead to a more hawkish Fed, a classic ‘be careful what you wish for.’

As the 3mo6mo yield curve inverts dramatically...

Inflecting right around the mid-October date of today"s auction...