Published January 24th, 2013
With global credit and equity markets raging, we are revisiting our risk indicators ? the ones we?ve been monitoring since 2006. Some are long term, some short term. Some are investor-sentiment driven, others meticulously follow systemic risk. By themselves they mean very little, but collectively they provide a 20,000 foot view of global market risks.
For the long haul, stocks are very cheap. A multiple with a 14-handle on this years earnings, after a 10-year flat run for stocks and a performance explosion for bonds, there?s no question where true value lies.
At the end of the day, performance in today?s markets will be governed by the entry point. Keep half your money in stocks for the long haul, use the other half to trade the politically driven fear and complacency. This is where the real returns will be found.
Since Lehman Brothers went bust, if you added to your stock market holdings during moments of real, politically driven fear and sold on complacent days, you would have outperformed the market by a long shot. But how is this achieved in practice? It is done by analyzing our basket of risk indicators, because they will always tell you how much risk is lurking in the markets.
So far in 2013, the S&P 500 is up 4.89% in only 15 trading days! Short-term, the next 45-days are a screaming sell.
Lets start with the most important part of our risk indicators; systemic risk. These are my favorite because they tell you just how big the drops may be, or how many floors the elevator may skip on the way down ? how severe a near-term sell off will be.
The Holy Grail of measuring systemic risk is by monitoring how much banks trust each other around the world. There were so many warning signs before Lehman; before the flash crash in 2010; before the 20% drop in the summer of 2011, and before the 10% May-June 2012 market dive in the S&P 500.
The closer you are to a ?Lehman Moment,? the more systemic risk is in the markets, which could take ten years to normalize. The VIX has spent more days above 30 in the last 5 years than it did in the previous 17-years combined. The Lehman effect will be with us for years to come.
If we look at the great financial panics over the last hundred years, (1907 and 1929) there is a healing period which follows with some of the most difficult to navigate waters. We?re not even half way home coming out of the 2008 great financial crisis. We must be ready for what?s ahead. Life changing turns are still coming our way.
The further we sail from Lehman, the longer the runs of complacency will be. In ?Colossal Failure,? we talk about the absurd period between 2004-7 where the market spent some 65 weeks without an 8% pullback.
If you look at VIX since 2008, you can see a clear psychological healing process going on. Investors still carry with them fresh scars from 2008, this limits the run time of those complacency sprints. The further we get from Lehman, the longer the runs of complacency will be. Look at this run we?re in now. It?s been 25 weeks and the market has gone without a 10% correction. The sell off we experienced from the end of September though the November 16th bottom was only 6%. It was the smallest systemic move lower in the market since Lehman, a sign that markets are trying to normalize.
Before that, the previous run without a 10% correction was Jan-May 2012? 5 months. The last two January?s are two of the best in the last 50 years; rare times indeed.
When looking at systemic risk, the key is to measure interbank lending trust. We all know banks trust each other today, but how much? Is there more trust of banks in Asia and Australia, than in Italy and Spain? You bet.
It was truly amazing in the early spring of 2011. The market lost nearly 20% between July 25th and Sept 1st, but big banks had been pulling away from each other from early May. This gave us a lot of conviction on the short side, and we subsequently made some great calls for our clients. What were we looking at?
In 2011 it was across Europe as banks were exposed to the price collapse of Greece government bonds. The global epicenter of systemic risk today is in Spain.
Instead of walking you through all of our risk indicators, we are drawing your attention to the most worrisome areas, and they are clearly outlined below. But remember, our sentiment is short-term bearish only. We do feel that for the long haul, stocks are cheap. Our overwhelming feeling is that this rally is a little long-in-the-tooth, and we should all raise cash to prepare for a mild storm.
1. Repo rates, EONIA
Banks have lots of assets on their balance sheets. They use these holdings to raise cash on a daily basis. If you know who to call, tracking the cost of this funding is a valuable risk measurement in the market. In the 9 month period before Lehman?s failure, the cost of short term loans like repos was sharply spiking. The same could be said about many French banks in the spring of 2011 as the world was concerned about their exposure to Greece. Today, banks in Italy and Spain are experiencing rising costs in this area. Our systemic risk score here is a 5 and rising.
2. A Breakout Short Interest on the Largest Banks
In 2007, we were watching this like a hawk in the USA. In 2012, once again it?s Spain and Italy. Lets face it, the smartest investors play on the short side. The Chanos?s and Einhorns of the world need to borrow large amounts of stock to take a position. Therefore a breakout in short interest in the major bank equities is a bearish sign. In the summer of 2008, early spring 2011 & 2012 there was a classic breakout in this indicator. Today, our systemic risk score here is a 5 and rising.
3. Two Month VIX Future vs. 8 Month VIX Future
Money flow from the 8 Month VIX Future into the 2 Month has been a solid short term risk off indicator. As money moves from the 2 Month VIX Future to the 8 Month, this has always been solid short term ?risk on? indicator. Why? Just about every hedge fund on the street has a risk manager in a trading capacity. At Lehman, we were long billions of dollars of high yield bonds and every day we could hedge our exposure. If the market crashed, we?d make money short equities, and lose money on our bonds. One of the watering holes where risk mangers reside is trading the VIX ? volatility. By tracking the 2s vs 8 month money flow you can see elephant footprints, see where the smart players are making their bets. Our systemic risk score here is an 8 and rising. The smartest money is charging into short-term protection.
4. Investor Sentiment
If you look at Hulbert newsletter writers, this tracks bullishness and bearishness among market pundits. Right now they recommend an 81% net long exposure, the highest since July 2000, the next highest December 2004, and May 2010. No matter how many people on CNBC tell you ?everyone is bearish,? track the numbers. Another good one here, only 24.5% of advisors in Investors Intelligence survey looking for a ?correction.? That is the fewest since 14-Sep when their number fell to 21.3%. That was the last market high when optimism was abundant. The September 14th reading was a classic short term top in the market, preceded a cool 7% drop. Our systemic risk score here is a 9 and rising.
5. Percentage of Stocks Above their 50 Day Moving Average
This week a remarkable 79.9% of the stocks in the S&P 500 hit the overbought level across our model. The chart below is a classic breadth measure. The market is extended here to say the least. As shown, 90% of the stocks in the S&P 500 are currently trading above their 50-day moving averages. This is the highest reading we?ve seen over the last year, and it?s only the sixth time we?ve crossed the 90% barrier since the bull market began in 2009. Bespoke research confirms these findings. Our systemic risk score here is a 9 and rising.
6. CBOE Put Call Ratio
When nobody?s buying puts, lookout on the long side, and when everyone is buying puts GET LONG STOCKS. The ratio hit a recent low this week at 0.73. When stocks made that recent bottom on November 16th, the ratio hit 0.86, a lot of investors were looking for downside protection. THE CROWD IS ALWAYS WRONG. The only way to beat them is to go the other way. Our systemic risk score here is 8 and rising.
7. NYSE New Highs vs. New Lows
This indicator is much better at predicting market bottoms vs. market tops. Peaks in NYSE New 52 week lows are a classic buy signal. The near 2000 all time record after Lehman, hopefully will never be broken. More telling is the MACD on New Highs / New Lows, when the 50, 100, and 200 day turn negative, it?s a solid sell signal. Our systemic risk score here is a 8 and rising.
8. High Yield Fund Inflows
If you look back over the last 10 years, most market tops take place around the same time of record inflows into high yield bonds, coming from the retail investor base. J.P. Morgan?s weekly analysis of European high-yield funds shows a ?413 million inflow for the week ending Jan. 16, which is the largest weekly inflow on J.P. Morgan?s records (which date back to 2005). Of this, ?56 million is attributable to ETFs. The reading for the week ending Jan. 9 is a ?180 million inflow. The provisional reading for December is an inflow of ?1.67 billion, and the 2012 total currently stands at a ?7.97 billion inflow. Our systemic risk score here is an 8 and rising.
BOTTOM LINE: Raise cash. Your exposure to the markets now should only be your core positions. If you are feeling brave, go short. Our goal is to point your ship into fairer winds. Good luck, and stay poised. We think a storm is brewing.
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