Macro | Cross Asset Correlation Update

The markets seem to slowly leave behind the massive focus on fiscal impulse following the US presidential election, and the inordinate amount of stress and optimism about the US dollar rally. This is already reflected at least in terms of asset price behaviours, if not media and analysts focus yet.

Cross asset macro drivers for 2017 YTD (based on first factors extracted from principle component analysis for each asset class) looks much like H1 of 2016, which saw a cautious rally in risk assets following the early stress period - albeit now it comes with reduced influence of oil prices and volatility on risk asset prices. This stands markedly different from the H2 of either 2015 or 2016 - which saw a pick up cross asset correlation (with very different outcome, a risk-off move in H2 2015 and a risk-on rally in H2 2016). The MST charts below captures this dynamics pictorially.

Among the risk assets, DM equity factor shows increased positive sentiments to rates (i.e. increased yields leading to rally). Inflation has become more important for DM equities as well, while FX has virtually no influence. For EM equities, the latest trends has been a slight de-sensitization to rates and FX movement, although they remain significant. The credit factor also picked up its correlation to rates (and FX, which is mostly influenced by EM credits part), while retaining correlation to inflation.

This makes the rates and inflation path the most important determinants for risk assets at present - at least from Developed Markets equity investors' point of view. Markets will always react (or over-react) to tax cuts expectations and presidential elections. But we are now, it appears, back to the basics.

On this fundamental note, we have seen some recent encouragement in global inflation space. The left chart below shows GDP weighted CPI inflation (global top 20 economies as well as Developed Markets within that). Since the recent bottoming out at start of 2016, we have seen a secular rise in inflation, which is more pronounced for the DM case. However, the core inflation scenario (not presented here) is far from running hot. Core inflation in the US and China have improved from 2015 lows, but much less dramatically. Only in the case of Euro area this has been solid (from very low levels). One the other hand, global credit growth (right chart below) appears to have topped out in a secular manner. On the positive sides, the wage growth in the US (not shown here) has been encouraging and sustained.

If we consider these points, in the context of extraordinary monetary accommodation that exists across the globe today, we should be more hesitant to conclude we are heading towards a definite normalization anytime soon, in spite of strong sentiments. The rates market seems to agree. We have seen inflation recoveries in 2011 (remember the ECB hike mistakes) and also in early 2014. It was a misfire in both cases. A weakening credit impulse and barely normal inflation in the face of extraordinary monetary stimulus represents a global demand which is far from recovered. This makes the case for removal of these extraordinary monetary measures very difficult - most policy makers are still biased to err on the upside inflation naturally. That is unless we see the whites in the eyes of inflation - in which case, it either may be too late, or have to be too harsh and steep. For now, the forward looking inflation measures (both market based like break-even inflation and model based like Cleveland Fed now-cast) remain stable without any sign of worrisome upward pressure. This means the risk assets will largely avoid negative reaction by a possible June Fed hike (market probability of 67% as of date priced in). The key risk in this regard remains any (mis-)communication or premature taper on the central bank balance sheets.

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All data from St Louis Fred Database

Macro: The Quiet Riot - Continental Version

For the past few weeks, the fixed income market has seen a significant change in moods.

The earliest trigger was in the JGBs market in late July, then it was the Gilts in late September following a pause from BoE. This week it definitely felt like the Bunds. Treasuries are down too from July highs, but in a much gradual fashion compared to the rest.

Now while we do have individual explanation (with the 20/20 hindsight) for all these (BoJ steepening chatter, Brexit, ECB QE rumors and, of course, Fed hike expectation), these moves signals some fundamental changes common across the markets as well. For one, this sell-off in rates is markedly different that recent large moves or the 2013 taper tantrum in terms of the accompanying movement of the inflation expectation. This is the first large sell-off in rates where the real rates (I used 10y yield less the 5y swap breakeven rate) were stable. Clearly the common thread has been inflation expectation - led by the Sterling inflation market, in response to a weakening currencies. But this was not limited only to GBP. Backed by the strong recovery of the commodity prices and oil, inflation markets across regions rallied, recovering from the bottom in Q1 this year. Even the Euro inflation is  flat on YTD basis after this recent move.

However, it is still too early to say if this points to an inflation scare. We are far off from seeing the white of the eyes of inflation. Large part of the recovery in inflation is driven by commodity prices which just came off multi-year lows. With over-capacity in many sectors, and a new cost/ supply equation for oil (see here too), there is no strong case for the commodity rally to overshoot substantially from here. On the demand side, apart from the healthy wage growth in the US, things are not significantly better. UK is still trying to figure out the consequences of Brexit. The collapse of the credit impulse in the Euro area late last year is yet to recover and Japan seems increasingly stuck.

The suddenness of the move suggests a large driver of the sell-off may be positioning, especially in Euro and GBP. Bunds open interest on Eurex were near historical high since 2008 before the selloff. This was definitely not helped by a rather tight-lipped Draghi on the last ECB. ICE Gilt positioning also indicated asymmetry with position build-up after Brexit. For core rates, this means the recent sell-off will stabilize as the pressure from positioning is diffused eventually. However, it is clear that we are approaching near the end of the era of quantitative easing. The next big move in rates will not be triggered by Fed. It will be the policy announcement from BoJ in Nov, followed by ECB's decision on QE in Q1 next year. Fed is priced in, and with all probabilities, will carry out a measured hike in December. It will be mostly a non-event.

What is rather interesting is how the current monetary policy plays out for the curve. It is clear we are increasingly approaching the end of QE-topia, with some central banks moving to normalize, and some still leaving considerable liquidity in the system and trying to lean on the next lever. This apparent divergence in the first order (the level of rates) is leading a convergence drive in the second order (the yield curve slope). BoJ is actively seeking to steepen the curve to alleviate concerns of the banking sectors, among other things. ECB will be glad to have the Euro area curve steepen back. The Fed is allegedly getting in the same business. The latest round of rates sell-off, unlike most before in recent time, was mostly a bear steepening move. Unfortunately, steepeners are not as juicy as they used to be in terms of carry a couple of years back, but still this is the trade to be in for the medium term - either in absolute term or cross-markets.

On the equity side, contrary to general view, this is not at all negative. Inflation recovering from current levels shows strength of the macro drivers. In fact in recent years, S&P 500 has shown more asymmetric correlation to inflation expectation than outright rates itself (see chart below). The thick tail on the right hand side has been dominated by inflation downside (i.e. correlated sell-off in equities with collapse in inflation expectation). A recovery in inflation expectation should be positive, at least initially, and ultimately uncorrelated to equity performance (runaway inflation is still a distance myth). This is especially true given the strong commitment from the Fed on its intention of slow paced hikes.

The S&P appears to be in a consolidation state - in a typical triangle formation, before the next leg (usually up from here).

The downside for equities from here is in fact event risks, and not macro. The US presidential election is one -although apparently the market does not care. Italian referendum is another - and again the history does not make a strong case for it either, if you go by the off-hand manner in which market digested the outcome of recent southern European election outcome.

Markets: Volatility Ahead

Finally we had a little bit of excitement back in the markets, and a vindication of sort for the numerous bears. Analysts from Citi confirm the macro drivers to blame. Indeed the cross market correlation has been on the rise. Below table shows the current cross market correlation¹. As it shows, rates and inflation still remain the major drivers, along with a very high level of correlation between commodities and currencies.

The chart below shows average correlation across asset classes. The recent spike is still far away from the levels around August 2015, but clearly captures the market sentiment.

And this sentiment is what is reflected in the latest AAII release last week. The market neutrals and bears remain significantly above the historical average as we have during most of this post-crisis bull runs. The change to highlight is an increase in bears at the expense of mostly the neutrals. 

For a contrarian, this would signal a limited scope of continued sell-off. However the other factor is positioning on the derivatives side. I have written about this before, but you must have already observed the change in the intraday price patterns in S&P. During much of last few months, it showed a strong mean-reverting characteristics (opening price shocks reversed during the day). For last few session starting from the 9th sell off, it seems the intraday trends are self sustaining now. That is confirmed on more quantitative measures as well. The chart ² below shows two approximate indications of short gamma positioning of the dealers. The idea behind this is in a market where the dealers (i.e. the hedgers, as opposed to players who hold options positions unhedged) are short gamma (net sellers of options), the natural hedging activity will create price pressure that will tend to amplify a price move (a up move in to a sustained rally and vice versa). On the other hand, when the dealers are net long, this will tend to stabilize price moves. Much of the stability in S&P intraday move for past few months can, at least partially, be attributed to net long position from the dealers, which appears changing now, as the short term intraday trends get stronger and sustain longer.

On the valuation side, however, S&P is still not screaming over-valued. Below chart shows world equity markets valuation vs trends (past 1-year returns) in two measures. The left one is the regular P/E measure, on which S&P is quite in the red zone, along with India and only second to Mexico. However, just going by historical P/E in a world of zero rates can be highly misleading. In terms relative valuation to bonds, S&P is quite in the middle.

If you followed the trades from my last post, it would have been a good couple of weeks capturing most of the major moves in the markets in the right direction. Looking ahead, if you are a bear, the investor sentiments and the valuation is not at a very helpful support to go big short at current levels. On the other hand the change in the gamma signature of the markets tells us unless something changed after Friday's expiry, we will continue to see decent swings and volatility will pick up. Although vols are not particularly cheap (relative to realized, yet), and I think given the reasons discussed before, it still makes more sense to buy options than to buy VIX here.

A traders' market after a long time. Brace for the upcoming Fed, but more for the BoJ. Going beyond equities, the major moves in rates (one of the major driers across asset classes now) has been set in motion by BoJ arguably. The recent bout of steepening in fixed income started with a bout of sell-off in JPY rates markets. This transmitted to rest of the world following ECB, with sharp steepening across EUR, USD, and GBP. The built up to the month end BoJ is almost palpable, and if not FOMC, at least this is almost certain to be an interesting event.

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1. This is based on smoothed data (Gaussian kernel smoothed with 5-day bandwidth) to capture medium-term correlation.

2. The left chart is based on identifying trends quantitatively using change point techniques. The idea is as trends become more sustaining the ratio of max to median trends will increase, as shown in the chart. The right hand chart shows absolute value of beta in a simple regression of intraday price to time, capturing the strength of the trend (if any) irrespective of its direction (rally or sell-off).
3. Data from Bloomberg and Google Finance

Trade Ideas: Macro Trades - The Fall-Winter Collection

The speech from Fed Chair in the Jackson hole was quite uneventful. The far more interesting was this one. It was a while back the ever useful Michael Pettis hinted at how rate cuts can be deflationary - exactly the opposite of mainstream central bank thought process. This represents another argument, and how crucial fiscal participation is in delivering monetary objectives.

Talking of central banks, this month is another one for central bank focus. Starting with ECB next week, followed by BoE around middle of the month, and ending with Fed and BoJ towards the end, the mood of the market is expected to swing based on these policy outcomes. The general expectation is a hawkish Fed while the rest continues the dovish stance. Here are the top 5 trade to consider for the moment.

#1: Pay USD 10y swap spread: USD swap spread was hammered just after the last FOMC hike in December, but now on a slow yet firm upward trend. Theoretically, swap spread should be determined by the expected futures spread on GC rate vs libors. While empirically this had little influence for US treasury swap spreads in the past, still this is an important metrics. And if you have not been gone for long for the summers, it is hard to miss the sharp widening of the spot spread of GC vs libor - mainly influenced by the sharp increase in libor rate. There is a good reason for this, as the market regulations kicking in forced quite a few prime money market funds from bank-issued commercial papers to US treasuries, pushing up the borrowing cost for the banks. It appears so far this yet has to be passed through the swap spread prices in any form or substance. On top, a pay position in swap spread (pay swap, receive treasury) has been highly directional with general rates levels historically. Given this correlation and the current levels (near the bottom of the trend channel), this represents an efficient position for any FOMC hawkishness, especially unexpected ones. This also benefits from a positive roll-down. In addition, this position is empirically should be somewhat long volatility - quite an asymmetric position at current levels.

#2: Pay GBP 10s30s steepener: Following Brexit, the long end sterling curve steepened sharply, followed by an equally sharp flattening after the early August BoE. This is presumably a reaction from the QE announcement, but it is not entirely intuitive. While we had similar sharp flattening move in Euro after ECB QE in early 2015, the large difference in size between this two perhaps points towards a bit over-reaction (ECB's initial €60b per month, later €80b, compared to BoE's £10b per month, i.e. £60b over 6 months). Not only in terms of absolute size, the ECB QE is also larger in comparison with the supply - for example at the ECB capital key, Germany amounts to approx €20b per month currently, compared to a gross supply of around €16b per month (as per Bundesbank projection figures for this years). For the UK, this compares to £10b per monthly to £11b of monthly supply (as per UK DMO projections). This does not correct for the German securities trading at an yield lower than ECB depo rate (and hence not eligible for QE), and also the fact that ECB QE will extend beyond the BoE one, hence the actual difference in supply pressure is much more acute. The second interesting point to note is the maturity distribution (see chart below). UK has a squeeze in the middle segment (belly, i.e. 7 year to 15 year remaining maturities) of the curve, whereas the squeeze for ECB is mostly in the long end, putting a relative rally pressure in the belly UK Gilts curve. Add to this the facts that the market price of expected inflation spread between UK and Euro area (breakeven inflation swap) has actually widened following Brexit. This is presumably influenced by the sharp decline in GBP vs USD, but this inflation premium somehow has to be priced in the nominal rates which in general should exert a steepening pressure. This combination makes a steepening position for GBP 10s30s attractive. One of the possible reason for such a sharp flattening can be the expressed intention of the BoE governor to steer clear of negative rates and that remains a risk (somewhat mitigated by a still 25bps to go). Other risk is a sudden strong recovery in UK economy, which will weaken the case for steepening.

#3:  Equity bearish protection: For all those bears out there, shorting the all time highs have been as appealing as it has been money loosing since June. The equity markets around the world has been quite oblivious to shocks. FTSE 100 had one of the best runs in Europe. European equities have been less spectacular, but nonetheless not in correction territory. Nikkei 225 handled strengthening yen better than expected. Even EM had a decent run. The key has been the amazing resilience of S&P 500 - and appears everything is now pending on a breakdown in the US equity market. As a result, S&P is now trading at tad lower from all time high, and tad higher than all time low realized volatility. On top, last print from CFTC traders positioning shows the highest ever short positioning in VIX. But there are potential issues on the horizon to be cautious, FOMC in September is the obvious one, South African political situation may be a trigger, or sometimes things just happen. Fortunately, we also have the S&P calendar vol spreads around the highs. This present a good cautious positioning of buying the near term puts vs long term (e.g. 3m/6m) - relatively less damning long gamma position. A large downside move in the US equity market will almost certainly have repercussion across the globe, and if triggered by FOMC, especially across the emerging markets.

#4: Pay Cross-currency basis widener in EUR: One for the long-ish term - this is a reversal of Euro savings glut trade. Since the start of the financial crisis, the cross currency basis widened as everyone panicked after dollar funding. Subsequently during the period of European sovereign crisis, this basis remained under stress, and only started normalizing after the whatever it takes promise from ECB's Draghi. However, after peaking at around mid 2014, this basis (not only in Euro, but across major currencies like GBP and JPY), started widening again. My theory is: this time it has less to do with financial market panic and shortage of dollar funding from the liability side, and more with the savings glut on the asset side. In such a scenario, asset managers willing to invest in higher yielding assets (like US treasuries or equities) will swap their euro funding with a euro vs dollar cross currency swap (effectively a dollar loan against euro) and paying dollar interest vs receiving euro interest. As more and more money chase this trade, there will be a receiving pressure on the euro leg, pushing the basis down. The fact that this is asset driven and not liability driven is corroborated by a flattish slope in the basis for different maturities. During the panic days, it was a strictly inverted slope (e.g. 1y tenor wider than 5y), which is now reversed or almost flat. Given this, any recovery in the euro area (and indeed globally) consumer and investment spending will set the direction in a reverse trend. Currently the levels are near short term support. Also given the slope as mentioned above, this benefits from a positive roll-down. This is a relatively low risk and low cost of carry trade for global economic recovery. The alternative is of course that long-dated forward trade in euro. But I like this one better at the moment: the long dated forward can remain stuck even after normalization (i.e. end of savings glut), but the basis will surely feel the pressure. Plus the once juicy carry in those long-dated forwards are mostly gone. Reportedly, there is currently a dollar funding shortage, on account of the money market regulation change mentioned above. But also reportedly a large part of the switch from CP to treasury is done.

#5: The ECB Trade: ECB is not BoJ and Euro area is not yet Japan. The question is if you see them converging or diverging. The chart below shows market reactions in rates and FX for recent major central bank decisions in Euro area and Japan. Note how in recent time, ECB meetings followed a rally in Euro and a flattening in the curve. Also note how the similar the reaction was in BoJ. And finally, how the last one from BoJ in July end, which underwhelmed the market, reversed the flattening trend, with less pronounced effect and in fact a net steepening. The story of QE is perhaps running out of steam.

I expect similar reaction for ECB even if they announce a QE extension beyond September 2017. The standard trade will be fading the move, which is as of today expected to be a steepener. However, a rally in Euro may be more difficult in the short term as the focus shifts immediately to Fed.

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All data from respective treasury offices, and Bloomberg.

Note To Self: Bear of The Dark

“Going negative is daring but appropriate monetary policy. But it is a sign of a terrible policy failure by fiscal policymakers.” - this succinct quote from former Fed official Narayana Kocherlakota captures the very essence of the limitation of the central banks today.

I started turning bearish - like most market participants - in early January. I turned neutral here, and bearishness followed. See here and here and here. That was mostly based on reading the market information and assessing them, subjectively. Which is NOT particularly a great way to develop an outlook. Here we attempt a more formal process.

A bad time to assess if the markets are turning a bearish corner is on days like today: the markets sell off a quite a bit. First thing one has to fight even before starting to reason are a whole bunch of cognitive biases!

Let's assume we have already done that. The next thing is to take an objective view, and establish based on the current information what are the chances of a bearish market setting its foot hold firmly.

First, the base rates: to start with, only the price information and no context whatsoever. First we notice we are in some kind of cusp. The 3 month, 6 month and 12 month performance of, say, S&P 500 are more or less similar within some tolerance. That means, we are not in a steady trend, yet, in either direction - bullish or bearish. In a steady trend, it is much easier (and almost useless) to establish if we are in a bullish or bearish phase. It is very difficult to predict a trend at the onset of it. Many investors spend considerably amount of time and effort trying to achieve this, and more often than not, they fail.

But looking at data, we can make some probabilistic observation. Here we look at the historical probability distribution of S&P 500 returns - over next 3 months and 6 months - when it behaved similar to today. That is: it sold of significantly (we look at 5%, 7.5%, 10%, 12.5% and 15% prior sell-off) and that happens in a turning phase (i.e. 3, 6 and 12 months performance are equivalent within some tolerance). Here is how it looks, since the post-world ear.

For next 3 months return distribution - on the milder sell-off side, the distribution tends to the usual - hardly useful to prognosticate. However, as the sell-off amount increases it tends to widen in a bi-modal distribution - tending to either settle down in to a bearish phase or come-back sharply. And only beyond 15% the upside skew tends to dominate. We are at around 12%. Looking at the next 6 months returns - the historical distributions are more extreme, and chance of an onset of bearish trends increases with increasing sell-off, till the upside skew tilts it in bull's favor beyond 15%.

The obvious conclusion here is we are not going to settle at this stage, and likely to move to one of the peaks. And we can also say, although with less conviction, the sell-off is perhaps not large enough to be perceived over-sold and is slightly tilted in favor of the bears.

Continuing with base rate case: Equity market is related but distinct from the underlying economy. One way to approach is to ask what are the chances of a sell-off given a recession, and also what are the chances the markets sell off anyways even without any recession in the economy.

Here is a list of historical recessions in the US since the great depression, and the corresponding market sell-off

So excluding minor recession introduced by sudden fiscal tightening or monetary tightening or the very distinctive dot com crash - the average sell-off has been around 12 percentage point per percent point of GDP lost. And roughly 30% on an average.

It can be noted that we had two occasions of a market sell-off (greater than 10% peak-to-trough) without any recessions - one during 1965-66, presumably under a credit crunch and followed by a recession. The other time was 1976-78, which was actually straddled by the 1973-75 recession and early 1980s recession. So the probabilities of a sustained bear markets without a recession is much less. But of course we are looking at a more globalized world now. Hence we can expect equity underperformance in the US even without a technical recession, if there is a large scale disruption else where in the world.

Overall conclusion - we have a considerable chance of a bear market setting in. Note, a 50-50 chance of a bear market is actually a much stronger conviction than it sounds. On a rough measures, since post war era till before the current phase, we have spend roughly a 30% of months in a bearish market. So unconditional probability of a bear market will be around 30%. And given the above observations, it should be higher than 30%. May be closer to, but quite less than 50%. A good number to anchor is mid-way at 40%. And this is a conditional estimate, without considering the context or forward outlook. It depends on the probability of a economic recessions, global or in a major economy. Which comes up in the next post.

As a tail-piece, here is how the classic equity risk factors are performing lately. This is in the US, but should be similar across the board.

The value is beaten down, and it is the momentum that is the last man standing.

Macro: The Chinese New Year

The gyrating market this week so far has more than done its bit to jolt people out of their holiday stupor. The Chinese equity markets and the law makers kept everyone, well, engaged. Late this afternoon we have seen some respite after the Chinese authorities repelled the stock circuit breaker rules. Equities rallied from day's low and bonds sold off. All fine and good. The question is, is it time to fade the market full of confused and panicked investors? Or should you panic yourself instead.

 

Whether the Chinese episode is something to worry about depends on the opinion about how in control the Chinese policy makers are, and what is their line of thinking. Chinese Yuan devaluation is not necessarily such a risk-off thing in itself. Arguably the Chinese authority looks at CNY against a trade-weighted baskets and not only dollars. And also in terms real effective exchange rates, Yuan is far from cheap, and a bit of regression to the mean (at whatever the authorities think it should be) should not cause so much pandemonium. Then again, it is not clear how much control the authorities have in executing these changes. Last year, and this year so far, most of the Yuan "devaluation" has been rather abrupt. This may be the communication policy of PBoC. But apparently that did not go well with the market. The re-balancing problem in China is a real thing. And it is just that, a re-balancing problem. If it can be controlled, with controlled devaluation and a smooth transition from investment based to consumption based GDP, and most importantly manage the debt from blowing off in between, this will be an adjustment.

 

If it is not controlled, it will be a crisis. Some are already calling it so. I tend to think it is not. Referring to someone who knows more about China than perhaps anyone else, there are encouraging signs in this rebalancing effort. The Chinese foreign exchange reserve is a hot issue in near terms. But more importantly, it is how they maintain the balance in the economy (low enough unemployment and no mass-bankruptcies) before they adjust to the new GDP paradigm is the most important question. And FX devaluation is a pretty smart and cheap way to achieve that. At a milder cost of a negative pressure on global inflation. Unless that creates a panic and becomes a self-fulfilling crisis.

 

Market seems to be focused on the second point of FX devaluation, fed by researches on where the level official reserve is and how much outflow it has seen in recent time. Remember how the Chinese market sold off massively in the June and rest of the world hardly noticed? And when that reversed in August when the PBoC revised CNY fixings. The question is how justified this fixation on FX is. The political economy in China is pretty much different than the developed nation or what we have seen in case of the Asian tigers or LatAms under sudden stop, The authorities, in principle, has much wider control on the economy. And if they do succumb to the sudden stop problem and that blows in to a full scale crisis with a collapse of asset prices, it will be felt far more geopolitically, than economically (apart from a certain global deflation, again). I would tend to assume so far what we have seen from the policy-makers are more likely to be mistakes and experiments than a sign of loss of control.

 

In the meanwhile, coming back to the original question, should to panic or fade? Statistically speaking, the odds are something like below (click to enlarge).

 

The charts shows the conditional upside and downside in representative equities after a given amount of weekly sell-off (the opportunity is the difference between upside and downside). It captures the next week's percentage move (vertical axis) given a percentage sell-off this week (x-axis). As we can see, with extreme moves come extreme opportunities. Equities so far sold off around 4% to 5% this week across markets. As you can see the time to jump in to wanton bullishness is still a couple of percentage points away, statistically speaking.

 

Note: these data sets excludes the wild days of 2008, but including them does not change the picture much.

NIFTY: Day traders Vs. Investors (+ A Christmas Present !!)

Here are some interesting charts comparing how S&P CNX Nifty has performed over last many years - split between day-session performance vs. overnight. The pattern is very interesting. In 2007-2008, the day traders dominated, both in profits and in losses. Be it the run up to the pre-crisis top in early 2008, or the crash. It was again the day traders who profited most in the comeback in 2009. This continued till the peak in 2010. 

However, after that, something changed. 2010 was the last great year for the day traders. Since 2011, the overnight returns dominated returns during the day session, far and steady. That was the case during the mild bearish runs in 2011, the sideways market in 2012. And the trend continues strongly in to the current bull period. 

The overnight returns now dominates day session so much that if this continues, going long overnight and shorting the markets during the day is now a super profitable strategy !!

What is driving this? Well to start with: the vols are down, and NIFTY (like most emerging markets) is perhaps influenced by the Feds and the BoJ much more than it used to be back in 2007. I would suspect most emerging markets will show very similar patterns. And this is VERY different than, say , S&P 500, where overnight and day-session has their fare share of misery and joy.

Will this continue? Well, the flow of funds that world-wide QEs initiated is still churning around, and will perhaps take a long time before the dust settles down. But it is an altogether different scenario if we enter a high vol regime in 2015, irrespective of market direction.

The tail piece: for folks looking for public source of intraday data on stocks - here is a quick and dirty R scripts. Feel free to use and modify as you please. Quantmod of course does a wonderful job for daily data. This routines are similar and extend to intraday.

Downloading intraday data from Yahoo or Google

. Merry Christmas and happy holidays everyone!

Freak Oil - Long Term Perspective

A long term look at crude oil price. And some fresh perspective.

Note the high correlation between bonds and oil price (correlation approx 90% on monthly differences)

And in spite the recent crash, oil still trades near all time high in terms of beer!!

This is NOT Nuts, Where is the Crash?

The secret of making money in the market is to bet against it and then be right as well. As a far-fetched corollary, we can also say when everyone is worried about a market crash, that is perhaps not the best time to actually position for a crash. Even if they are central bankers warning of over-valuation of certain stocks or warning of outright market crash. Central bankers have not shown particular excellence and consistency in timing the markets. Keywords charts for "asset bubbles" and especially "market crash" bursting through the roofs here!

So here we take a look at the global market valuation. We have all range of valuations, from downright moribund Russian stocks to upbeat Mexico. And these excludes much of emerging and frontier markets. As good as a time to stay invested for long term, as any other time. And look for value.

And the markets seem to understand. We have hardly seen any great shift in momentum in equity flow. We have seen recent outflows in emerging market debt, high yield and developed markets equities. And also some increased flows in to US and core Europe bond funds. But before you listen to financial analysts and talking heads, there are very little evidence of flight to safety here. On longer term, what we are seeing is NOT rotation, rather a reflation, i.e. money continues to flow in to both bonds and equities. This is corroborated by central banks flows of funds accounts, as well as other higher frequency flow data. The amount of recent outflows from US equities is dwarfed by the amount pumped in since the financial crisis.

There are reason to believe these latest rounds flows in to bonds has little to do with safe heaven demand. The unforeseen consequences of changes in regulatory landscape (BASEL 3, SOLVENCY 2, all leading to higher bonds demands) and austerity and stress on balanced budget (leading to lower supply) may be the major driver. Clearly yield chasing has been significant as well, but there is some amount of caution out there - see the recent outflows of high yields. The real dangers are the developed economies getting in to the next recession following a natural business cycles from a much lower peak than past recoveries, and a China problem. But none of these present an extreme tail scenario to me. And if your expectation is a total Chinese melt-down, then heaven save us! So unless we see a central bank induced shock therapy gone wrong, a crash may never come anytime soon. At least not when everyone is looking for it! 

And even if it does arrive, probably it will be safer to stay in equities than in fixed income

And, oh, if someone tells you the evidence of irrational exuberance in the equity market is the insane levels of margin debt on NYSE and/or the cheapening of put skew, just sigh and shake your heads.

Macro View Series: Cross Country Market Cap To GDP

Out of sheer lack of actions in the market (which I hope will change with the NFP and ECB tomorrow, the ADP came in great today), we take a look at cross country relative equity valuation. That is basically a vague sounding smartspeak for checking out the market capitalization of listed companies (as a % of GDP). Market cap to GDP is a quick and dirty way to compare fundamental valuations across countries, assuming fundamentals matters in your trade horizon (so we are talking long term here). Of course, this ratio will be influenced by, among others, share of unorganized sectors (inversely proportional) and proportions of productive companies listed (directly proportional), and claim on other countries' GDP (like Switzerland - a home of many multinationals, directly proportional)

We look at two aspects. First, the market cap to GDP vs real GDP growth rate - this kind of gives how the market prices in the expected growth in earning vs price. 

Also we look at the ratios with comparison to investment share of GDP. Note the countries are presented using internal country code (ISO 3166) here.

From the above we see a certain patterns. Most economies lie with reasonably narrow band no the 2nd chart. Look at the outliers - like on richer side Switzerland and Singapore. Both are financial hubs and home of many multinationals. So we naturally expect the market cap to GDP ratio to be higher. However, the South African and Malaysian markets are suspect of overvaluation. On the cheaper side you have Venezuela, Argentina and China. Venezuela and Argentina have their own pressing problems. And China is, well, China. So hop over them, and you see the suspects for cheap valuation: Kazakhstan and Czech Republic

Now the fun is to look in to more details of the specific economy and convince yourself. Happy hunting!

And here for the tail piece: the market cap to GDP ratio for India and US over the years (approximated from BSE 500 and S&P 500 market cap respectively)

No Merry Note, Nor Cause of Merriment

The revisions of US 2014 Q1 GDP so far. Comparing the contribution to real GDP

Contribution to real GDP in percentage points (from BEA)

Most of the revision is basically from PCE, and the rest from EXIM (both exports and imports worsened). This is just a point estimate, but will definitely cause some serious re-think on the recovery. The PCE has been the flagship of US recovery so far. And this prints definitely NOT good.

If US enters a recession, inspite of QE3, that will shake the confidence of the public in general, and will not be exciting for equities. Are we back to rates rally?

Most of the other data, including something that you can rely on, like Federal Reserve FoF data, still show encouraging trend. So I would say nothing to worry as of yet, but be watchful.

Yet Another India Vs China Story

A very interesting piece from IMF Direct blog!

It captures how the trade integration within Asia has phenomenal compared to other regions globally for last two decades, centered on the China growth story. And it also highlights how this has resulted in increased synchronization, and increased propagation of growth shocks between regional partners. This, is claimed, has given rise to a high correlation among Asian economies, as they provide this chart for quick evidence

And when I look at this chart, I find India has a pretty interesting position. In fact some might argue, based on this chart, that betting on a Chinese shocks can be structured through short Australia and Korea and long India and Philippines, adding statistical leverage.

Although I am doubtful this negative correlation in economies will translate to the correlations in markets in the event of a severe chines slowdown. Irrespective of how good or bad the economic story is, India will face consequences on international financial flows if we see a real serious slow down in China. The question is what happens when the dust settles down. India is a net importer from China, with some overlaps of export to other developed countries. So certainly will suffer much less directly through a slowdown in China. In fact can even benefit from reduced competition in global markets. But by any means economic downturn of the second largest trading partner is no good news, even if it runs a net trade deficit.

But if the slowdown in contained, I think there will be some focus on this issue and India will see some part of the flows from the Asia focused funds, trying to limit Chinese exposure

In fact, long-term market correlation supports this. NIFTY has been much more correlated to S&P 500 ...

... than Shanghai Composite