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MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE

This week's notable callouts include a new YTD high in the TED spread and continuing widening of US and European financial CDS. Our Macro team's quantitative levels for the XLF show a high probability of a squeeze in the XLF (23% upside to TRADE resistance, 1.2% downside to TRADE support) before the bear market trend takes hold once again.  


Financial Risk Monitor Summary (Across 3 Durations):

  • Short-term (WoW): Negative / 2 of 11 improved / 6 out of 11 worsened / 3 of 11 unchanged
  • Intermediate-term (MoM): Negative / 2 of 11 improved / 8 of 11 worsened / 1 of 11 unchanged
  • Long-term (150 DMA): Negative / 1 of 11 improved / 8 of 11 worsened / 2 of 11 unchanged

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - summary

 

1. US Financials CDS Monitor – Swaps widened across domestic financials last week (20 of 28 issuers widening).  On a month-over-month basis, not one issuer was tighter.  The largest moves were at BAC, MS and LNC.

Widened the most vs last week: C, MS, HIG

Tightened the most vs last week: RDN, CB, XL

Widened the most vs last month: BAC, PMI, MTG

Widened the least vs last month: ACE, CB, MMC

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - us cds

 

2. European Financials CDS Monitor – Banks swaps in Europe were mostly wider last week.  28 of the 38 swaps were wider and 10 tightened.   

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - euro cds

 

3. European Sovereign CDS – European sovereign swaps were wider week over week across the continent. We are keeping a close eye on France, which is critical to the EFSF, and where swaps widened by 4 bps (to 154 bps) week over week. We believe the CDS market is currently pricing in decreased hedge effectiveness in addition to improvement in sentiment around sovereign solvency.  Judging by the Greek bailout, regulators are making a concerted effort to design a bailout that does not trigger CDS.

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - sov 1

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - sov 2

 

4. High Yield (YTM) Monitor – High Yield rates fell last week, ending at 8.20 versus 8.27 the prior week.

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - high yield

 

5. Leveraged Loan Index Monitor – The Leveraged Loan Index rose 5 points last week, ending at 1514. 

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - lev loan

 

6. TED Spread Monitor – The TED spread rose to a new YTD high, ending the week at 30.3 versus 28.0 the prior week.

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - ted

 

7. Journal of Commerce Commodity Price Index – Last week, the JOC index fell further to –5.2 from -3.6.

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - JOC

 

8. Greek Bond Yields Monitor – We chart the 10-year yield on Greek bonds.  Last week yields rose 110 bps, ending the week at 1664.

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - greek bonds

 

9. Markit MCDX Index Monitor – The Markit MCDX is a measure of municipal credit default swaps.  We believe this index is a useful indicator of pressure in state and local governments.  Markit publishes index values daily on six 5-year tenor baskets including 50 reference entities each. Each basket includes a diversified pool of revenue and GO bonds from a broad array of states. We track the 14-V1.  After bottoming in April, the index has been moving higher.  Last Friday, spreads closed at 155 bps.

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - mcdx

 

10. Baltic Dry Index – The Baltic Dry Index measures international shipping rates of dry bulk cargo, mostly commodities used for industrial production.  Higher demand for such goods, as manifested in higher shipping rates, indicates economic expansion.  Last week the index rose sharply off a very low level, climbing 175 points to 1462.

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - baltic

 

11. 2-10 Spread – We track the 2-10 spread as a proxy for bank margins.  Last week the 2-10 spread tightened a further 20 bps to 187 bps.   

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - 2 10

 

12. XLF Macro Quantitative Setup – Our Macro team’s quantitative setup in the XLF suggests bias to the upside as follows:  23.2% upside to TRADE resistance, 1.2% downside to TRADE support.

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - XLF

 

Margin Debt Continues to Fall

We publish NYSE Margin Debt every month when it’s released.  This chart shows the S&P 500, inflation adjusted back to 1997, along with the inflation-adjusted level of margin debt (expressed as standard deviations from the long-run mean).  As the chart demonstrates, higher levels of margin debt are associated with increased risk in the equity market.  Our analysis shows that more than 1.5 standard deviations above the average level is the point where things start to get dangerous.  In May, margin debt decreased $9.5B to $306B.  On a standard deviation basis, margin debt fell to 1.21 standard deviations above the long-run average.

 

One limitation of this series is that it is reported on a lag.  The chart shows data through June.

 

MONDAY MORNING RISK MONITOR: BEAR MARKET SQUEEZE - margin debt

 

Joshua Steiner, CFA

 

Allison Kaptur


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THE M3: JULY CPI

The Macau Metro Monitor, August 22, 2011

 

 

CONSUMER PRICE INDEX FOR JULY 2011 DSEC

July CPI increased by 5.96% YoY and 0.51% MoM.  Price index of Recreation & Culture, and Transport rose by 0.94% and 0.85% MoM, respectively, with higher charges for outbound package tours, airfare prices, and ferry tickets.

 

 




Uncertainty and Non-Linearity

“Linearity isn’t the norm in the world around us, non-linearity is.”

-Dan Gardner

 

That’s another quote from the book I referenced last week that I am in the middle of reading – “Future Babble – Why Expert Predictions Fail and Why We Believe The Anyway.”

 

What’s interesting about both Chapter 2 (“The Unpredictable World”) and the book is that it’s really accessible for non-scientifically inclined readers. You don’t have to have a Ph.D. in fractal math or applied physics to grasp the deep simplicity of a few very important concepts – Uncertainty and Non-Linearity.

 

In Hedgeye’s Research and Risk Management Process, Uncertainty is critical to accept. Maybe that’s why our models have had very different signals than consensus during both the 2008 and 2011 Growth Slowdowns. Wall Street/Washington models tend to command some level of certainty in their baseline assumptions. Being absolutely certain about models that don’t work is a problem.

 

In the real-world of accountability, successful Buy-Side Risk Managers like Ray Dalio (Founder of $100B Bridgewater Associates) have embraced Uncertainty as a core component of what it is that they do. As Dalio says in John Cassidy’s New Yorker article (“Mastering The Machine”, July 25, 2011):

 

“I’m always trying to figure out my probability of knowing... Given that I am never sure, I don’t want to have any concentrated bets.”

 

I love that.

 

Defining Non-Linearity is a little more complex. But, essentially, that’s the point – and why we’ve built all of our models and processes on Complexity (or Chaos) Theory.

 

Clients often ask me for reading primers on Chaos Theory. Here are a few:

  1. Complexity – The Emerging Science At The Edge of Order and Chaos”, by M. Mitchell Waldrop
  2. Deep Simplicity – Bringing Order to Chaos and Complexity”, by John Gribbin

After having consumed both of these books, you’ll realize that neither contain any applied market models. And that, too, is the point. Accepting Uncertainty and Non-Linearity in your risk management process is something that you have to really come to embrace in principle before you apply it to what it is that you do.

 

In “Future Babble”, Gardner doesn’t do Chaos Theory like I do, per se, but he does simplify the difference between Linear and Non-Linear systems. “Gravity, for example, is linear in mass. Double the mass and you get twice the gravity” (page 39). “A common component of non-linear systems, feedback, involves some element of the system looping back on itself…” (page 40).

 

I like that explanation because it’s simple. To a degree, Non-Linearity also rhymes with what George Soros calls “reflexivity.” And, again, in principle, it takes a fundamental acceptance that this is what drives market prices, volumes, and volatilities before you can really apply it to what it is that you do.

 

Back to the Global Macro Grind

 

What it is that the US stock market continues to do is go down. Last week, with the SP500 closing at 1123 (its lowest weekly-closing-low of 2011), across all 3 of our core risk management durations (TRADE, TREND, and TAIL), US stocks are bearish/broken:

  1. TRADE (3 weeks or less): resistance = 1166
  2. TREND (3 months or more): resistance = 1294
  3. TAIL (3 years or less) = resistance 1256

When Perma-Bulls call this a correction, I’m not quite sure what they mean.

  1. Since its 2007 bull market cycle-high of 1565, the SP500 is down -28.2%
  2. Since its 2011 bear-market rally to a lower-long-term high of 1363, the SP500 is down -17.6%
  3. For 2011 YTD, the SP500 is down -10.7% (the Russell 2000 is down -16.8%)

Now before the bulls get to point #3 they’ll be jumping out of their seat saying, ‘but, the SP500 is still up +66.1% from its March 2009 closing low.’ OK. It really would be ok if the Perma-Bulls were in 100% Cash at the 2009 low and bought everything for their clients right then and there – but I’m pretty sure that didn’t happen.

 

In Q3 of 2008, I took the Hedgeye Asset Allocation Model to 96% Cash.

 

In Q3 of 2011, I’ve now taken the Hedgeye Asset Allocation Model to 70% Cash (versus 64% at the beginning of last week).

 

I guess that makes me relatively bullish compared to 2008!

 

Into Friday’s straight up move in Gold and Silver, I took our Commodities allocation back down to 0% (I sold our entire Silver (SLV) position). There are no rules against buying that or a long position in Gold back. Long-term returns are cumulative and gains compound. The market doesn’t particularly care what I own on any particular day.

 

Making money starts with not losing money. And while I am painfully aware of how hard it is to actually execute on that strategy at the end of bear market rallies (2007 and 2011), I’m also very respectful that long-term returns in this business are both Non-Linear and Uncertain.

 

My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1, 79.84-84.69, and 1108-1166, respectively.

 

Best of luck out there this week,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Uncertainty and Non-Linearity - Chart of the Day

 

Uncertainty and Non-Linearity - Virtual Portfolio


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