What Are We Waiting For?

By: Michael Ashton | Thu, May 26, 2011
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What, has everything gotten to fair value, so there isn't any volatility any longer? The VIX index, despite everything that is going on in Europe, is back near the lows of the last four years (last month a 14.62 was recorded; today the VIX is around 16.3). The chart of the VIX has the self-similar nature of an EKG or a seismograph (see Chart), with spikes of decreasing severity ebbing with a similar decay function.

Seismograph or VIX?

I don't know what that means, exactly. With the tension in the European sovereign crisis paused, but certainly not released, it surely doesn't mean an "all-clear" has been sounded. I suspect it is also a function (as everything else is) of the low rate/low return environment. Low expected returns make it harder to buy options, since a bigger part of your return is going to pay for them, and more tempting to short since the income from a strategy of selling covered calls - which I enjoy reminding people is the same thing as selling naked puts, and watching their faces when they realize it's not a particularly conservative strategy when you put it that way - or straddles is noticeable. I sure can't figure out why selling options here makes sense, even if it might look like a good idea for a while.

The data continues to be sluggish, but at this point it may just be a temporary lull as sometimes happens in the ebb and flow of data, or the direct or indirect effect of the disruption stemming from the disaster in Japan. Yesterday's Durable Goods was bad, even ex-transportation and even with upward revisions to prior numbers. Today, Claims remained elevated at 424k with an upward revision to last week. The longer this lasts, the more confusing the "Japanese impact" becomes to interpret. Is the impact lasting longer, or is there other weakness as well? Or is the disruption rippling down the line slowly?

One Wall Street sell-side shop I saw did an analysis that said auto production should be down 10% for a short time, which they said meant that (with 700,000 workers employed there) there should be a 70,000-job "Japanese effect." But that's not right, because each worker doesn't contribute an equal number of cars. The math (0.1 * 700,000 = 70,000) is good, but the economics is bad. Assuming for illustration that every worker is doing the same job, basic microeconomics says that labor is added until the last "marginal" hires are producing just barely enough to justify that hire. Therefore, if you cut production 10%, and assuming that you cut the least efficient workers, you'll cut employment more than 10%. (This of course would only be literally true in a stylized situation where the cost to hire and fire is zero.) There are also secondary and tertiary effects that trickle down, and we just don't know how big those are - we merely know the sign.

Equities rallied today, Greek bonds rallied, the bond market rallied (10y Treasury yield down to 3.06% and looking for all the world that it wants to go back below 3%), TIPS rallied (10y TIPS down to 0.73%), and Unleaded rallied while NYMEX Crude fell to $100 again and the dollar declined. But with the exception of bonds, all of these markets are consolidating. Volumes continue to be pitiful in stocks, as they have been all year. Not since March triple-witching has NYSE volume been higher than 1.04bln shares. In fact, since I last showed this chart the aggregate volume for 2011 has begun to march off on its own. Compared to 2010, average volumes per trading day are a full 248 million shares per daylower.

Cumulative Annual NYSE Volumes
Wall Street isn't exactly a ghost town, but volumes like this aren't good for the big boys.

And this begs the question - what are markets waiting for? Are bulls waiting for something good to happen, or for something bad not to happen? Are bears waiting for something bad to happen, or for something good not to happen? It is much easier for something - good or bad - to happen than for it to not happen, which is an open-ended statement. This may sound weird and convoluted (but that is sometimes how I think), but I believe the bears (on the economy and on equities) are waiting for something bad to happen while the bulls are waiting for bad things to not happen.

If I am right about that, then it means the bulls are essentially in a short-options position. That was fine when the market was priced at a level that permitted some bad things to happen without derailing everything (similarly, implied volatilities were extremely high, which allowed someone to sell them and be okay even if some things went wrong as long as a lot of things didn't go wrong). But stocks, and economic expectations, are now at levels that reflect an assumption of no-bad, despite the obvious list of things that can go wrong. Bulls have had a good ride for a while as nothing really bad happened, but now that 'option' is a risky one. Gains will be trickling in like time decay, while bad things could strike quickly and move the market sharply lower. Although I am a former options trader, and comfortable with selling options when the circumstances and pricing are right, I experience a visceral reaction against selling cheap options.

In this discussion I separate the bond bears from the equity bulls, because I think the arguments are different for bonds. Both bond bulls and bond bears face conflicting pressures from the economy and from central bankers, and whether you're bullish or bearish depends almost as much on your assumption of the central bank reaction function to weak or strong data as it does to the data (as well as any non-data calamities) itself. This is a confused mess, and the bond market is rallying by default in a risk-filled world. With rates falling, the technicals are bullish but I don't see it as an easy trade to go along with the move. It may be that the bears need to be good and flushed by the time QE2 ends before we can have a bearish move, but I still think the eventual path-of-least resistance is to higher rates. But do I want to be short US bonds when Greece defaults?

As many observers have lamented, very little about equity and bond strategy right now has anything to do with economic data. Being bullish or bearish has more to do with evaluating political games (in the Nash sense) than the latest figures. But even if we're not good at guessing what is going to happen next behind closed doors, that's okay - the evidence is pretty clear that investors as a whole are pretty bad at guessing economic outcomes as well. It simply makes it more clear that we need to focus on the range of possible outcomes, and the risks and rewards associated with those possible outcomes. Even if we can't handicap the probability of those outcomes, we can look for patterns such as the one I think I see right now: that stocks are an options bet. And we can take action to constrain the results of that bet, by trimming our exposures to stocks (my exposures across the board, except to commodity indices, are already pretty low).

The only economic data due tomorrow is the monthly Personal Income and Consumption data (Consensus: +0.4%/+0.4%, with +0.2% expected in the PCE Price Index) and a revision to the Michigan Sentiment data. Neither of those are normal market-movers anyway, and with an early close ahead of a three-day Memorial Day weekend the focus will be on trimming positions against headline risks.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

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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