Stock futures are up sharply after another week of unprecedented volatility. Although last week was relatively tame, only 13 times in the last 60 years has the S&P 500 had a down 1% day during the week between Christmas and New Year’s. We managed one of those days last week. We also had a 1% positive day. Futures are strong and looks like stocks will open above 1272 (where they closed on Jan. 3, 2011).
Not only does volatility remain elevated, the stories are about the same. We have some new acronyms to contend with, but ultimately the European Debt Crisis (it is both a bank and sovereign crisis) and the strength of the US economy and China’s ability to manage its slowdown are the primary stories. Issues in the Mid-East remain on the fringe but threaten to elevate to something more serious with Iran flexing its muscles more and more.
So what to do? Prepare for more headlines, more risk reversals, and more pain.
There are a few “consensus” trades that particularly scare me. It is almost impossible to find anyone positive on European stocks or US Financials. Finding someone positive on European Financials is impossible. Back on December 15th we started to believe that going long Europe vs short the US made sense. Too much “decoupling” had already been priced in. I think that trade continues to make sense.
My belief that the LTRO does reduce funding and liquidity pressure on banks could provide some support for those stocks. I don’t believe in the “carry” trade hype of LTRO but do think that between last month’s LTRO and the one coming up, the liquidity concerns will diminish. The fact that the banks are all depositing money at the ECB shows that they don’t intend to use it to source new assets, but will use it to deal with debt redemptions. This is a benefit and given how many people seem pessimistic about the banks longer term (myself included), it might be enough to spark a rally. More surprising, to me, has been the willingness of governments to support the banks without forcing shareholders dilution. Governments seem willing to help banks fund and are not acquiring equity stakes (certainly not at a significant discount). That surprises me, as I expected governments to try to actually get some value for their citizens, but it looks like they have bought into the argument (made by banks) that bank share prices equate to banks’ willingness to lend. That argument is flawed, but if the governments are willing to help the banks without charging for it, then they could continue to perform well. I expect JPM will have a very strong quarter. They come out on January 13th. They had a relatively small gain due to their own credit spread widening (“DVR”) in the 3rd quarter, and at the time, seemed to be conservative about releasing reserves. I expect they will increase reserve releases to more than offset any DVR give back. C is the next big bank to come out, but not until January 17th, so strong JPM earnings could be enough to whet investors’ appetites further. Once BAC and MS are done reporting on the 19th and 20th the shine will be off the financials. BAC seems to be a mess and is hard to guess what will happen, but MS is likely to have a weak quarter. They settled with MBIA this quarter, booking a big loss. Their 5 year CDS went from 161 at the end of June, to 490 at the end of September, but is back to 415 at year-end. That should result in some significant DVA losses. Since the CEO was so happy to take the gains back in October (as opposed to JPM which seemed almost embarrassed to book those sorts of profits), I can only hope he bought back a lot of cheap debt to lock in some of the gains. Obviously in this headline driven world, anything can change in a moment’s notice, but these points are worth considering as the year starts.
More broadly, the view seems to be that we will start the year modestly or even weak, only to rebound later in the year. I have trouble believing that since I think Europe is not close to being resolved, that our own economy is only doing okay at best, and that China is in worse shape than the data shows. So, if the consensus is wrong, it is that we will start more weakly than most investors believe and that we will not bounce and in fact will do even worse in the second part of the year. That would suit my views, but wouldn’t cause me enough pain. The pain trade might be a much much much stronger start to the year. Enough strength to make all the shorts cut and for all the underweight bulls to fully load up, only to be followed by a disastrous sell-off. I think a move like that would cause the most pain and damage to market participants, and seems far enough away from the consensus, that although I don’t really believe it could happen, it is worth thinking about.
How could such a strong rally be ignited? Nothing is fixed, but there is such overwhelming bearishness in regards to European Stocks and all financials, that there might just be enough tinder there to ignite something. The spark might be a continued shift by policy makers to focus on Small Enough To Manipulate (“SETM”) Markets. Clearly, pretending that they could solve Italian debt problems in the secondary market didn’t work. It is just too big. Now they are focusing on the “auctions” rather than the secondary markets. Each auction is relatively small and relatively easy to manipulate. Coerce some banks to participate, push some EU money at it, let dealers whisper to hedge funds how “cheap” the issue is and how much demand there is, and “voila” you have a successful auction. Convince market data sources to reference the bonds you want them to as “benchmarks” and manipulate those. FX rates might be hard to manipulate, but take a market like basis swaps, and manipulate the heck out of them. Flood them with central bank money, convince banks not to play in them, and “voila” you have created another benchmark that tells a positive story. Why are Spanish yields so much lower than Italian yields? The one explanation that makes sense, is that the market is so much smaller, it has been easier to manipulate. I think we will see more targeted efforts to make the markets seem healthier than they are. They won’t be that convincing, but with continued high volatility and a complete lack of liquidity they may well work for brief periods.
Credit ETF’s and CDS Indices
HYG and JNK have both done well. Although they offer a decent “spread” in this environment, the duration is low, and the convexity is fairly bad, and they are both trading well above NAV. On HYG we are neutral, and actually prefer JNK right now because it is trading at less of a premium, and the weaker portfolio would outperform if we get a grab for yield in the underlying bonds. HY17 actually seems a better long. It looks relatively cheap and still has a lot of “decompression” trade shorts. It also has some bad shorts from other markets, so am slightly more interested in being long HY17 vs either of the ETF’s.
LQD is also only marginally appealing. It is trading a bit rich to NAV and has too much rate/duration risk for my tastes. On the other hand, I could see the financial component rallying significantly here. On a “hedged” basis (short some treasuries against it), LQD is more appealing. Spread compression seems more likely than outright yield performance given where treasuries are. IG17 at 119 isn’t particularly appealing. I don’t mind it, but it seems like far more IG17 shorts have been taken off than HY17 shorts. I also believe there is a decent amount of long Main, short IG out there, on the “decoupling” theory, and that too could come under some early pressure, creating a bid for IG17.
TLT (or the other treasury ETF’s). Is this the year to finally be short? With QE and Twist and the Fed in general supporting the curve, it is hard to be short, but this asset class probably has more muzzled bears than any other credit asset out there. After being wrong 5 years in a row (or so), most of the treasury bears seem very silent, but they are still out there, waiting for the opportunity to jump on the bandwagon.
MUB and BABS should continue to do well. On a treasury hedged basis these are our favorite credit ETF right now. They survived last year and look reasonably cheap. We have started to see stories pointing out how wrong Meredith Whitney was, which could help demand as retail investors decide they won’t be open to ridicule at a cocktail party if they say they are long munis. MCDX is just too thin and not diversified enough for me to focus on at these levels.
For a fling, some longer dated (lowest price possible) Italian bonds might be worth a shot, and buying some Greek debt may be worth a short. Italy is a bet that any degree of stabilization sees a temporary bounce in their bonds, and Greek bonds seem cheap enough to own some and see how the negotiations play out. If banks really do agree to a 75% haircut, any bonds that didn’t participate should do better. If there is a “hard” default, and that drags in bonds held by the ECB and pension funds, then the pressure to offer a recovery of closer to 50 would be higher, and the bonds could do well. Picking some with a coupon due in January might not be bad as you aren’t paying 100% for the coupon and it seems unlikely any resolution to the Greed debt default/restructuring/haircut/comedy occurs before the end of January.