Sovereign Debt For Dummies

“Who can be wise, amazed, temperate and furious, loyal and neutral, in a moment? – No man.”

-William Shakespeare

On US stock market weakness yesterday, I moved from bearish on US Equities to neutral. On the margin, that’s a bullish shift. Everything that really matters in our macro risk management process happens on the margin.

Can you be loyal and neutral at the same time? Can you be temperate and furious in the same moment? Who can be wise about economic history’s lessons and, at the same time, manage risk daily, unemotionally attached?

In risk management, neutral is as neutral does. Going into yesterday’s macro morning I had more shorts in the Virtual Portfolio than I had longs, I was short the SP500 via the SPY, and I was carrying a cash position of 67% in the our Asset Allocation Model.

This  morning I have 12 longs and 12 shorts in the Virtual Portfolio. I am no longer short the SP500 (SPY), and I have doubled our asset allocation to US Equities from 3% to 6%. I made these moves on a market down day. Yesterday was the first down day for the SP500 in the last five. Can I be bullish on the Dollar, bearish on Treasuries, bearish on China, and move to neutral on US Equities? Apparently yes.

This morning is like every morning. This morning it’s time to play the game that’s in front of me. Yesterday is for the revisionist historians to figure out. They are very good at that – let’s not interrupt them.

From my trusty daily market diary, there are 3 immediate term macro factors staring me in the face this morning:

1.       Chinese Ox In a Box (Chinese stocks were down another -0.69% last night, taking YTD performance for the Shanghai Composite to -9%)

2.       Buck Breakout and Rate Run-up (both the US Dollar and 10-year yields continue to make higher-lows after brief selloffs)

3.       Sovereign Debt For Dummies

Before I focus on that last point about sovereign debt (yes, it sounds like a Hedgeye Macro Theme brewing here in New Haven for Q2), let me say this: managing global macro risk doesn’t occur in the vacuum that the manic media sucks you into. It’s multi-factor; it can be furious; and it can be temperate. The art in managing around all of these global risk factors can be found in orchestrating at the extremes of consensus.

Sovereign Debt For Dummies is a book we might collaborate on with some folks on Yale’s campus. With both Spain and Greece trading down -0.82% and -1.2%, respectively this morning, there is plenty a CNBC pundit with Perceived Wisdom who is racing to call these out as negatives embedded in weak pre-market open US futures trading.

On an absolute basis, the risk management point associated with what we call a negative divergence (for example a country index like the United Arab Emirates trading down -2.2% this morning is a negative divergence versus the DAX in Germany which is flat on the day so far) is crystal clear. Spain and Greece are negatives today, but what are they telling us about what might happen tomorrow? Will the sovereign debt bears be loyal to their short positions, or will they be forced to move to neutral?

Context, of course, is one of the most critical factors you’ll need to answer that question. Historical price momentum, volatility, and volume studies will help you too. These should all be in the index for Sovereign Debt For Dummies. So we’ll work on that…  

When it comes to analyzing sovereign debt, Ken Rogoff at Harvard is no one’s dummy. He was very early in quantifying and cataloging history’s lessons on piling debt, upon debt, upon debt. We were at least earlier than the dummies in calling out what Rogoff was calling out. For accountability purposes, here’s what I wrote in my Early Look from 12/23/09, titled “Standing Still”:

One of the most misunderstood global macro risks in the market today is that of sovereign debt defaults. Many market pundits are brushing off what is happening in Middle Eastern debt, Eastern European banks, and Chinese property stocks as isolated events. Standing still into year-end with that opinion is very risky.
 
Sovereign defaults, as a percentage of total global defaults, remains at a generationally low level. That can change. Carmen Reinhart (University of Maryland) and Ken Rogoff (Harvard) wrote a great book in the last year titled, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”, that provides the best historical context of this critical risk management point. So rather than rehash their work, I will refer you to the Amazon.
 
The simpleton question that every global risk manager should be asking themselves is this: if sovereign defaults are near all-time lows, and sovereign bailout debt issuance continues to hit all-time highs, how do you think this is going to all end? Until we know, I can assure you of this – we don’t know. That’s what I call risk.

No, this isn’t me saying I am smarter than you. This is just a friendly reminder that managing risk doesn’t happen in a vacuum. There are proactive risk managers you can follow in the marketplace like Reinhart & Roggoff, and then there are reactive dummies who are trying to short the SP500 this morning because Spain and Greece are trading down (note Spain, Greece, and the United Arab Emirates are all down -12% for 2010 to-date already – this isn’t new).

Not unlike Niall Ferguson at Harvard being the most cited US Dollar bear back in November (at the bottom for the Bombed Out Buck), or Nouriel Roubini being the most sought after speaker on the Wall Street Group-thinking Conference Circuit of early 2009 (at the US stock market bottom), sometimes academics find a way of making big long term bearish calls, but also marking the intermediate term peaks in consensus fear associated with those calls.

Ironically enough, this is the #3 most read story on Bloomberg this morning: “Harvard’s Rogoff Sees Bunch of Sovereign Defaults.” Nope, I couldn’t make that up if I tried. It’s not like this guy just published his book last night folks. So realize this, Sovereign Debt For Dummies is now the most consensus macro fear we have seen since the Burning Buck was in 2009. And every fear and fury has a funny way of being neutralized, in the immediate term, at a price.

My immediate term support and resistance lines for the SP500 are now 1099 and 1122, respectively.

Best of luck out there today,

KM

LONG ETFS

XLK – SPDR Technology — Technology is underperforming the SP500 YTD; a down day on 2/22/10 prompted us to buy more. We expect to see some positive mean reversion for Technology as M&A picks up.

UUP – PowerShares US Dollar Index Fund — We bought the USD Fund on 1/4/10 as an explicit way to represent our Q1 2010 Macro Theme that we have labeled Buck Breakout (we were bearish on the USD in ’09).

CYB - WisdomTree Dreyfus Chinese Yuan — The Yuan is a managed floating currency that trades inside a 0.5% band around the official PBOC mark versus a FX basket. Not quite pegged, not truly floating; the speculative interest in the Yuan/USD forward market has increased dramatically in recent years. We trade the ETN CYB to take exposure to this managed currency in a managed economy hoping to manage our risk as the stimulus led recovery in China dominates global trade.

TIP - iShares TIPS — The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield. We believe that future inflation expectations are mispriced and that TIPS are a efficient way to own yield on an inflation protected basis.
 

SHORT ETFS

EWU – iShares United KingdomThe TREND of higher y/y inflation and stagnant growth = stagflation. For a country with the UK's balance sheet and leadership problems, that’s not good.

 

GLD – SPDR Gold We re-shorted Gold on this dead cat bounce on 2/11/10. We remain bullish on a Buck Breakout and bearish on Gold for Q1 of 2010, as a result.

 

RSX – Market Vectors RussiaWe shorted Russia on 2/9/10 and maintain our intermediate term TREND bearish view on the price of oil.

XLP – SPDR Consumer StaplesGiven how many investors own Consumer Staples stocks because it was a "way to play the weak US Dollar" last year, we have ourselves another way to profit from a Buck Breakout with this short position.

IEF – iShares 7-10 Year TreasuryOne of our Macro Themes for Q1 of 2010 is "Rate Run-up". Our bearish view on US Treasuries is implied.