Monday, April 14, 2014

A case of "risk exhaustion"?

Stock markets have been selling off for a couple of weeks, but there has been no apparent fundamental underpinnings to the decline. While I can point to technical reasons (see my last post Stocks: Short and medium term outlook), satisfactory fundamental explanations have been lacking. That is why we have seen commentary like this one from Matthew Klein with advice to ignore the market and watch the data:
There are also plenty of real economic data, such as tax withholdings, that indicate the economy is getting stronger.

My suggestion: Ignore the fear-mongers, the day-traders and the hysterical wing of the financial news media. Don't make big changes to your portfolio or hoard canned food just because a few expensive tech companies are now a little less expensive. If I'm wrong and we end up repeating 1929, just remember that I would have spent today relaxing on my super-yacht if I really knew what the markets were going to do, instead of writing this post.

A crowded trade in risk
Then I came upon analysis from Citi credit strategist Matt King whose explanation of the sell-off made the most sense to me. In essence, King believes that the market has been living on borrowed time (via Business Insider):

The one on the left shows credit spreads (light blue line) relative to corporate leverage (dark blue). As you can see, credit spreads remain extremely low (meaning corporations don't have to pay much more to borrow than the risk-free rate at which the US government borrows at) while corporate leverage is climbing. This, King worries, is in contravention of historical patterns, and evidence of an economy on borrowed time.

The left chart relates to the stock market and it shows that even though earnings revisions (dark blue) have been generally negative for the last few years, stocks have done quite nicely. Again, to King this represents a break from fundamentals, and he notes that the break in equity market fundamentals coincides with the break in credit fundamentals.
The markets could experience a Wile E. Coyote moment because fixed income investors had gotten overly long risk in a very uncomfortable way:
But with credit investors likewise mostly long and uncomfortable, could what starts as a position correction turn into something much more serious? After all, it’s not just tech where valuations have become disconnected from fundamentals. As our US HY strategist put it after seeing numerous CLO investors this week, “Whatever the asset class, the pattern is the same. Investors are long risk, invested in assets that aren’t their usual holdings, and wondering who is buying their old paper.” Wherever we go, investors think their market is expensive – but are forced to buy it anyway...
 The unwind could get very ugly:
Try a bit harder, and you could paint a bleaker picture still, in which investors may be coming perilously close to realizing that market levels owe everything to central bank stimulus and nothing to an improvement in underlying fundamentals. What if the much heralded “improvement in earnings to match the rerating in the market” fails to be delivered in coming weeks? How long till investors realize that extra stimulus in Japan might stem the Nikkei’s decline, but is unlikely to generate the economic recovery everyone is hoping for, no matter how large its size? And that the problem afflicting China – that the growth rates to which investors have become accustomed are utterly reliant on an unsustainable expansion of credit – is in fact a problem worldwide?
Star bond manager Jeff Gundlach agreed with King's assessment that the junk bond market had gotten very overpriced and he reducing his junk exposure. Indeed, the high yield market have started to roll over against high quality corporate bonds. As well, we have seen a similar kind of risk unwind in equities as the high flying IPOs, biotechs and other momentum stocks crater in the last few weeks.

Could this sell-off be just be a case of "risk exhaustion" by hedge funds and institutional investors? Under the circumstances, the rotation from Growth stocks to Value stocks makes perfect sense.

Correction timing and magnitude
BoAML strategist Michael Hartnett has also observed the de-risking effect, which he calls a  “hard reversal” (via Marketwatch):
January to April: The “hard reversal” period has seen emerging markets, bonds and gold, the losers of last year, become the winners of this year. They’re replacing 2013′s stars — Japan, Nasdaq and the U.S. dollar. But that reversal period ends in April. He cites two reasons:

1. So-called “extreme positions” are being eliminated fast. Since BofA’s last March Fund Managers’ Survey in mid-March, emerging-market equities have outperformed the Nikkei by nearly 1,000 basis points (in dollar terms).

2. Policy makers will turn dovish again. He says watch Nasdaq 4000 [the index closed below that level Friday], $2.20 on the Brazilian real, 66 on the PHLX/KBW Bank Index and 2.5% on the U.S. 10-year Treasury yield. “The biggest risk is that markets lose trust in vacillating Fed, the only policy maker the market truly trusts,” said Hartnett.
He went on to forecast a 10-15% correction in the stock market, but not yet:
September, correction time: Hartnett says bull markets don’t usually end with such high cash and low leverage, and also rarely end with tobacco being the only subsector at an all-time high. Bears looking for that big 10%-15% correction should wait until September and then buy volatility and up cash levels as Fed QE ends and rate-hike expectations grow for the Fed’s Sept.17/Oct. 29th policy meetings.
I agree that a 10-15% correction is in the right ballpark (my own estimate is 10-20%, but it's close enough for government work), but I do not necessarily agree on Hartnett's timing for the downturn.

David Kostin of Goldman Sachs pointed out that the current risk unwind has a lot further to go, if history is any guide (via Business Insider):

In addition, BoAML's ‎Head of Global Technical Strategy MacNeil Curry noted that the stock market has historically not seen a tradable bottom until the VIX rises above 20 (via ZeroHedge):
Since 2012 most tradable market lows have come only after the VIX has pushed north of 20%. It is currently only 17%.

In such an environment, US Treasuries should rally further. Indeed, US 10yr yields have broken below key resistance at 2.608%/2.632%, exposing the long term pivot zone of 2.469%/2.399%. The Japanese ¥ should benefit as well. The 200d in $/¥ is key (100.81) A break below would do significant psychological damage and force out many trend followers.

When I put it all together, the typical midterm election year scenario as outlined by Sam Stovall makes perfect sense and is the more likely outcome:

For now, the US macro fundamental outlook looks fine. In fact, we are seeing some evidence of a weather related growth snap-back from the cold winter. As well, Europe is recovering nicely. So there is no need to panic over falling stock prices.

This may just a case of the markets suffering a case of risk indigestion and exhaustion.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.


Anonymous said...

So if I get your conclusion right, you are seeing a 10% - 20% pullback in Q2 - Q3 ?

Cam Hui, CFA said...

The short answer is "yes". My base case scenario calls for a 10-20% correction this summer