Notes on the Market Set Up
The market continued to trade in Robotrader fashion again this week. Late yesterday I decided to add to my S&P put position for February, as my Januarys were expiring worthless. Since I am playing for the “big break”, I buy puts out of the money, which limits my loss of capital some if the silly season carries on. For example if the underlying SPY is 143, I buy the 141 strike price. I have a streaming quote set up that also allows me to track implied volatilities (IV) of options. IV of course measures speculative expectation of risk and volatility. As I began to enter my trade I was shocked to see IV trading around 9 for the 142. Normally the closer to the at the money current price the lower the IV. The 143 was trading about the same. In fact I have been shocked to see IV below even 15 for over a year now, but 9 really takes the cake for measuring zero fear.
Given how cheap the Feb 142 put was I decided to buy it rather than the 141, and entered my put price at the bid, which actually would be an IV of close to 8.75. Incredibly twenty seconds later and actually on a slight down tick of the underlying, the trade went off at the bid. My eye was transfixed on the IV, and I swear I bought those SPY puts for a 8.7 IV, which has to mark the lowest in history. Gee I thought, I bought for lowest IV ever, and ironically I may not even make money on it.
I was stunned, and thought to myself, what are these put sellers thinking? Talk about picking up nickels in front of steamrollers. Even ignoring the credit erosion I blog on regularly, what kind of world do they think we live in? What for instance would be the outcome if Israel or the US attacked Iranian nuclear development facilities over the weekend? Or instead of another silly season LBO, we saw a couple of these events announced in sequence only five times larger?
Another tie in to this complete lack of risk aversion came from this doozy. Again what on earth are the Riskloves thinking?
Dow Jones CDX North America Investment Grade Index, based on the bonds of 125 companies with investment-grade ratings, fell 4.3 percent this week to 31.99 from 33.42 on Jan. 12, according to data compiled by CMA Datavision in London. It’s the lowest level since the index was created in 2003. The perceived risk of owning bonds rated below investment grade also hit a record low this week, Credit Suisse Group data show.
More of this pattern comes from the emerging market debt and equity markets. A remark from my son describes this set up to a tee. He is an extremely worldly young man and speaks two foreign languages, Turkish and German, fluently, and can get by on a few more. He spent a whole winter packing around Brazil; he worked at the US consulate in Istanbul, Turkey, and now is with the consulate in South Africa. He’s taken side trips to Mozambique and Zimbabwe ( I had a cow on the last one). As readers know I spent most of November hazarding highways in Turkey with him. I also traveled with him in colonial Mexico. His area of expertise is developing or emerging nations, and he has even set me straight on some things. He is not especially bullish or bearish on them, but just realistic. When I described the puny spreads being paid on emerging market debt, he said the following, sounding I suppose like father, like son:
“Umh, that’s very strange. I wonder how many of these “investors” have ever even been out of US malls? And if they do travel abroad at all, it’s probably to Tuscany or some beach resort. I don’t think they have a clue.”
John Hussman offered an insightful comment on how these extreme situations get resolved, and I totally agree. This set up has the feeling of a big trap written all over it, where participants are convinced all declines are stemmed at 1% or 2% at most. Thus I strongly suspect it will come as a “thief in the night”, and will be transmitted into a dramatic pickup in downward volatility, and a credit spread spike. I don’t think players will even have the opportunity to get much confirmation from charts (although perhaps EEM above offers one?), as the sharp break will come right out of so called healthy looking uptrend channels.
One of the striking features that emerges is the abruptness of the declines. -10.5% in 30 days, -12.3% in 50 days, -36.1% in 38 days, and so forth. The first several days of decline from a market peak has often erased weeks and sometimes months of prior net gains.
An additional tie in to all this is the astonishing level of carry trade shorting of the Yen and Swiss Franc. Large speculators are now net short 45% of the open interest of the JY. Although it is a smaller currency, speculators are now net short 61% of the open interest of the SF. Again, talk about picking up nickels in front of steamrollers.
In conclusion a reader posted the following related article from the Financial Times, with perhaps the part in bold part answering my question about the Riskloves motivations. While I’m at it, I wish to really thank those who have been adding relevant comments, articles, and news items to each topic. I feel this has developed into a real value added feature to my efforts as a blogger, and would encourage all my readers to also review the comments section as well.
January 19 – Financial Times (Gillian Tett):
“Last week I received an e-mail that made chilling reading. The author claimed to be a senior banker with strong feelings about a column I wrote last week, suggesting that the explosion in structured finance could be exacerbating the current exuberance of the credit markets, by creating additional leverage. ‘Hi Gillian,’ the message went. ‘I have been working in the leveraged credit and distressed debt sector for 20 years . . . and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past. ‘I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions . . . with very limited capacity to withstand adverse credit events and market downturns.
‘I am not sure what is worse, talking to market players who generally believe that ‘this time it’s different’, or to more seasoned players who . . . privately acknowledge that there is a bubble waiting to burst but . . . hope problems will not arise until after the next bonus round.’ He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. ‘Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors’ capital - a 2% price decline in the CDO paper wipes out the capital supporting it.’”
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