The T-Report: An Animal House Market

Posted by on Jan 25, 2013 in The T-Report | No Comments

Was it over when the German’s bombed Pearl Harbor?

One of my favorite movie scenes as not only is the quote so wrong as to be funny, but everyone just “rolls” with it. Which I think is actually relevant for today. For the past two sessions the S&P (and fixed income) have done nothing on the surface but experienced some incredible moves in individual stocks.

Yesterday Apple lost almost $60 billion in market cap but the market was unchanged.

Wednesday, Apple, Google, and IBM added almost $30 billion in market cap but the market was unchanged.

Apple beat earnings estimates by 2% and missed on sales by 0.7% yet the stock moved 12%. The legendary cash hoard which continues to grow is now irrelevant. Analyst after analyst started to cut to hold and/or reduce price targets. It was their best quarter ever in earnings, stock, not so much.

Netflix beat by a big % on earnings, but only $0.25 per share. They beat on sales by 1.2% yet the stock was up 40%? I’ve owned some biotech companies that reacted like that to some FDA announcement (which is binary) but can’t say I’ve seen anything much like this for a company that merely executed its stated business model reasonably well.

IBM was up 5% on a 2.7% beat on EPS and 0.8% beat on sales. Seems like a lot, but at least there I can close my eyes and pretend to understand the magnitude of the move.

Google was up 6% on a 1.4% EPS beat and a 1.6% miss on sales. If I had these earnings in advance I’m not sure I would have bet on a 6% gain. Sure, it is all in the details but this seems less than obvious.

All of these examples scare me because they seem extreme moves and these are big companies. The bears (myself included) got extremely lucky on Wednesday that the overall market didn’t respond, and it seems like the bulls got very lucky yesterday. But what if we get a “correlated” day?

Extreme Moves

I keep looking to see if there is some obvious reason that the market wasn’t correlated. Was it so obvious that what drove IBM and Google would be negative for other companies? I don’t see it. News played out in a way that made it happen. Same for yesterday when nothing much about Apple was obviously good for other companies. Just the news playing out in a certain way, which leaves me very concerned we are about to get a big day.

I remain bearish, but while I thought we could see a grind higher in markets, I didn’t think the upside was “unlimited”. Now I am growing concerned that there could be a massive upside day. Had banks played along with Google and IBM, that could have been a 2 or 3% up day. I don’t understand it, don’t agree with it, but I don’t think we can ignore these massive moves.

Stock Prices are Just Numbers, Not a Valuation

I think more and more prices are behaving as a number. The huge community of day traders and funds with tight stops and funds with momentum strategies and algos that are happy to oblige them just whip things around. Over the longer term, some form of valuation has to kick in, but in the short term, it looks more and more like a game of hot potato and everyone trying to trade the next move up or down. Frankly that is scary to me and means that overshoots are not only to be feared, but to be expected.

So what to do?

Nothing has changed in my view that stocks here are overvalued. The data and the earnings have done little to change that, and in fact mostly encourage me that valuations are stretched.

Having said that, the moves of those 4 stocks makes me rethink things very seriously.

I am looking at more options with VIX low and volatility relatively cheap in other markets (CDS indices for example) as a better way to play.

Trade what you think will benefit and not what you think will do well indirectly. If you think Japan is going to do well, buy Japan (up 5% YTD), but if you think Japan will do well because of devaluation, then put on the currency hedge or if you feel exotic, do it in quanto form (Nikkei in USD is flat on the year). I think the same is true of bonds. Investors are nervous about corporate bonds (and very long) but are picking CDS to short. While the index is rich versus fair value, CDS as a whole seem cheap compared to bonds. I remain short IG19 in our “best ideas” but am considering cutting that or reversing. As of yesterday the idea has been a wash, as of today down small. I’m not there yet, but thinking about this and looking closely. This is certainly a “gut check” sort of day for any bearish trade.

Banks and Bank CDS

Personally, the pricing I understand least is bank CDS. JP Morgan’s market cap is getting back to pre crisis highs. The company is doing great, particularly from a fixed income investor’s perspective as they are being forced out of riskier business. That may hurt earnings growth (bad for the stock) but should create stability (good for credit). There is absolutely no evidence that the Fed won’t support banks in every way possible. For all the talk about too big to fail, every single piece of evidence points to the fact that banks remain too big to fail and the Fed will act more aggressively and earlier to prevent something from happening. JPM at 84 bps on CDS, have to say that seems cheap.

I was at an interesting CME presentation yesterday on clearing. It still seems like a lot of uncertainty of how it will work or how it will change the market remains, but I suspect that could be a positive catalyst for bank CDS spreads. As risk moves away from bilateral contracts to clearing, maybe there will be less need to hedge exposures to banks.

It has been a long time since banks traded better than corporates, since banks were considered safe, but maybe that will be the next leg of the credit bull market? Real money investors seem to have shaken off their fear of financials and if anything have been hurt by being underweight, so maybe that drifts into CDS next.

Long Spanish/Italian 10 year vs Bunds

This trade has been working and is having a stellar day today. While I am getting nervous that Europe is getting complacent – the number of “crisis solved” headlines is getting ridiculous, I think this trade has more room to run.

In the chase for yield, Spain and Italy still offer some yield. The longer the ECB’s plan is seen to work (all about perception and hopes of a plan) the more encouraged people will be to take risk. The original buyers were 3 year (as covered by OMT) but that has been leaking to 5 year. The 10 year is next.

Spanish and Italian bonds are heavily owned domestically. Most of those accounts are not “trading” accounts. The banks tucked the bonds away in hold to maturity accounts so they can accrue the interest and avoid the price volatility. Those bonds aren’t coming out, so the float is controlled.

Investors who “avoided the PIIGS” are now underperforming their peers and benchmarks. If last year it sounded smart to avoid those bonds, this year it looks like you missed the trade. Missing it may be the right decision, but the pressure is on to invest so some money will find its way and someone will get more aggressive and decide the best way to play catch up is to add some duration.

This week is the first time this year I have been nervous about this trade, but for now leave on and let it work.



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