Sunday, April 26, 2015

This is NOT Nuts, Where is the Crash? (II)

With dollar index on record highs, emerging market equities (except, of course, China!) getting bullied around on fed hike scare, and as the Greek saga continues, investors around the world are beginning to worry about risk trades. Especially equities and high yields. IF I am not mistaken, the latest Bloomberg investors survey points to that direction. Well, it seems we need not worry, not as yet! The Risk-On is going still very much strong.

I take the major equity indices around the world along with treasuries and internal sovereign ETFs (iShares) as well as high yields, and run some PCAs. The correlations as below.

The first one is obviously the risk-off/ risk-on factor. The second one is more like a fixed income allocation factor. The last one is domestic (US) vs international factor. We pick up the first factor and run it through a regime switch model (a Hidden Markov Model). The results below. The figure shows S&P Performance (orange) vs. the probabilities of different states we may be in. State 3 (bottom-most in black) represent Risk-On, state 2 (middle in black) is the Risk-Off state, and state 1 (top most in black) can be construed as Risk-Moderation state for lack of better words. As we can see, we are very much in Risk-On (click image for bigger picture).

Given the general nature of flows, esp smart money flows, chasing asset price momentum, we can say that much touted crash/ correction is a bit further away in to the future. Interestingly, similar analysis for other factors along with the assumption above means, for domestic investors, US fixed income is becoming increasingly less attractive, and foreign FIs more so.

1. if you are wondering about the title, part I is here)
2. data from 2010 onward, analysis and plots by depmixS4 and Quantmod package on R 

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