Disquiet

By: Michael Ashton | Sat, Feb 19, 2011
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Like all traders who have done it for long enough, I have several habits that I have developed over the years to cope with winning and losing streaks. For example, if I look at a chart and I really think it looks bullish, I will sometimes turn around and look at it upside-down; if in that position I think it really looks bullish too, then I know that what I'm seeing is actually what I want to see. Sometimes, when trading doesn't seem to be playing out quite like I expect it to - not merely losing money; losing sometimes is a part of trading, but losing in ways that are surprising me - I push my chair back and, as New Age-y as this might sound, I try to listen to my feelings. Really good traders (of which I am not one) can tell when their subconscious is urging a change of action. I have been around some good traders like that, but the classic example is probably George Soros. His son explained in Soros: The Life and Times of a Messianic Billionaire that:

"My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking...at least half of this is bull----. I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it's this early warning sign."

So maybe there's something to this.

When I lean back now, I feel an uneasiness - a disquiet. This isn't because the market has been going up and I'm not on board. I am on board, and maybe some of what I feel is that I'm far closer to my neutral policy mix than I should be given valuations. But there is something spooky in the way the rally is unfolding. I don't feel comfortable in my chair. To be sure, I have felt for a while that the rally didn't make a lot of sense, but it never made me feel like my posture was off.

Incidentally, I suspect that one reason the market has been doing what it has been doing - a slow, extremely steady march higher on light volumes - may be because one of the more popular trades over the last couple of years has been the covered-call gambit in which calls are written against a portfolio position for a little "extra carry." It is generally sold as something to do in range-bound markets, which is what many people expected out of 2010 (of course, put-call parity tells us that selling a covered call is functionally equivalent to selling an in-the-money naked put, but I'm not here to harsh on this popular strategy). The problem with it is that if the market rallies through your strike, your stock is called away and you are forced to buy it again, or to buy the option back before expiry, if you want to remain long.

If lots of people were pursuing such a strategy, you would see declining implied volatility despite dicey economic and geopolitical risks. The VIX currently is as low as it has been since July 2007, around the time of the first serious mortgage rumblings. (In the summer of 2007, most people thought the "subprime problem" was contained, and not many people were particularly concerned about it. The market was just about to set a new (nominal) high.) So this fits. It also fits the character of trading, which seems lackadaisical and as has been well-documented, low-volume. People aren't running to "put money to work" and adding to their positions aggressively. They seem to be buying...reluctantly.

I am not saying that the market is exhibiting a sense of disquiet, though. I am saying that I am feeling uncomfortable in some way. That being said, there are some odd incongruities out there. The headline on Risk.net "ECB overnight lending rockets to 19-month high" (incidentally, if you don't subscribe to Risk.net a little trick is that you can just put the headline into Google and a link will take you to the full article) caught my attention. It is expensive to borrow from the ECB. It could just be a one-week glitch for some reason, but it is curious. The 3-month Euribor rate hasn't done anything interesting in the last week, but it is trading above where it was in the middle of Q4 when there was a turn premium included. Maybe someone else is feeling the vague sense of unease that I have.

The behavior of oil, given the striking wave of political unrest in the Middle East, is strange but seems less strange if you look at Brent Crude (over $102 and near a post-2008 high) than if you look at West Texas Intermediate (WTI), which is around $86 and seven bucks off the highs. But that discrepancy in itself is odd. Brent crude oil is deliverable into the NYMEX contract, but not vice-versa, so pure arbitrage isn't possible, but the ICE Brent contract is cash-settled based on local commercial-size market trades so if Canadian oil is gushing into Cushing, it is surprising that a $15/bbl discrepancy isn't enough to persuade someone to fill up a tanker and deliver it into that market. In any event, there has been a lot of ink spilled on the difference between the contracts but it doesn't seem obvious to me that there is a definitive answer. In any event, even the Brent contract hasn't responded in the usual, spiky fashion to the widening circles of unrest in the Middle East - the rally has been slow and steady. Is there no risk aversion? What is going on here?

I have trouble believing that all of the crosscurrents are simply canceling: gradually-building economic strength in the U.S., widening violence in the Middle East, China's efforts to slow its economy (on Friday China raised reserve requirements slightly, but unlike when the CCB hiked interest rates a couple of weeks ago the market seemed to ignore it), signs that inflation is starting to rise, continuing debt problems in a number of European countries and uninspiring leadership on our own debt problems in the U.S.. Could it be that everyone is just confused?

Well, count me in that group. I don't feel right, so one thing I am going to do is to cut my equity positions down. If that doesn't make me feel less disquieted, maybe I'll try increasing them.

I'm not happy with this article.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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