Tuesday, June 30, 2015

Time for a market bounce?

I have written about my Trifecta bottom spotting model before (as an example see Sell Rosh Hashanah?). It consists of the following three conditions, which must occur closely (within a week) of each other:
  1. VIX term structure (VIX/VXV ratio) inversion
  2. NYSE TRIN more than 2
  3. My favorite intermediate term overbought-oversold model, which consists of the ratio of % of SPX stocks over their 50 dma/% of SPX stocks over their 150 dma less than 0.5
Each of these conditions, by themselves, are indicators of market fear. When used conjunction, however, they have been uncanny at calling short-term market bottoms.

The chart below shows the record of this Trifecta model in the last three years. I have marked in blue vertical lines where conditions 1 and 2 were satisfied, but not 3; and in red where all three were satisfied. In every one of the cases in the last three years, we have seen a short-term market bottom.

Trifecta Model: 100% accuracy in the last three years

We saw conditions 1 and 2 triggered yesterday, on Monday June 29, 2014, though the overbought-oversold model was not.

While the three year track record of this model has been remarkable, we need to put the results into context as the stock market has been rising steadily since the 2011 bottom. Such an environment is highly conducive to a class of models that spot oversold conditions, without worry that the market will get even more oversold.

I stress tested the Trifecta model in 2010 and 2011, when the market suffered major corrections and was far more choppy than it had been in the last three years. Though the results were still good, it was not perfect. The chart below shows the corrective period in 2010. In one case, the model signaled a minor rebound that petered out in two days. In another, it was too early as the market got even more oversold as the market fell to its final bottom about a week later.

We can see a similar pattern in 2011. The Trifecta model was too early in August 2011 as the market got even more oversold as it fell to its first bottom. September saw a number of multiple signals that were somewhat confusing. Though these multiple signals were consistent at flashing short-term bottoms, the stock market chopped around for several weeks before it began its ultimate rise.

So we can see that the Trifecta model is very good at flashing an oversold extreme, but does this represent THE BOTTOM for the current downdraft? That depends on a judgement call on the kind of market environment we are in. Are we still in the steadily rising market environment that we have seen in the last three years, or are we seeing the start of more serious market correction?

VIX spike bottom signal
Bill Luby at VIX and More had a slightly different take in a post where he wrote about stock market reactions to VIX spikes. Monday's 34% VIX spike was highly unusual and he found that it was generally an indicator of a short-term market bottom, but stocks tended to fall after a 3-5 day bounce (emphasis added)
Note that based on the data for the 23 VIX spikes in excess of 30%, the SPX has a tendency to outperform its long-term average over the course of the 1, 3 and 5-day periods following the VIX spike. Also worth noting that that 10 and 20 days following the VIX spike, the SPX has a tendency not only to underperform, but decline. Further, while the huge decline following 9/29/2008 VIX spike tends to dwarf the other data points, even when you remove the 9/29/2008 VIX spike it turns out that the SPX still loses money in the 10 and 20-day period following a VIX spike. When the analysis is extended out 50 trading days, the SPX is back to being profitable, but performing below its long-term average. On the other hand, when the analysis includes 100 days following the VIX spike, the SPX is back to outperforming its long-term average.

With the caveat that this is a limited data set, it is still worth flagging the pattern in which following a 30% one-day VIX spike, there appears to generally be a tradable oversold condition in stocks that lasts approximately one week, followed by a period of another month or so in which the markets typically has difficulty coming to terms with the threat to stocks. One quarter later, however, all fears are generally in the rear view mirror and stocks are likely to have tacked on significant gains.

Bill`s work with VIX spikes, whose history goes all the way back the the 1990`s, is suggestive that we are seeing a 2010 or 2011. If that`s so, it is consistent with the hypothesis that the market rallies into the July 4th long weekend and retreats afterwards.

The Greek referendum wildcard
We will see the results of the Greek referendum this weekend. The latest real-time signal from Lakdbrokes, indicate that the Yes side is leading with a probability of 63% compared to 37% for the No side. Such expectations are likely to create bullish tailwinds into the referendum on the weekend.

Even if the Yes side were to prevail, it is unclear how the markets might react to such a vote. Will it rally further because Greek tail-risk is off the table? Or will it retreat because the Syriza led government will likely collapse, which leaves Greece rudderless in the face a July 20 ECB repayment deadline which would implode its banking system (for more details see my post Time to buy GREK?).

Watching for the O'Neill follow-through
If the market were to see a bounce into the weekend, one way to decide if we have seen a durable bottom is to watch for a William O'Neill follow-through day, which is believed to be the sign of an intermediate term market bottom:
Summarizing the rules:

Day 1: Once a low has been established (after a correction), Day 1 occurs if the close is near the high of that day or a higher close occurs on the day after the low.
Day 2: The price must remain above the established low. If the price moves below the Day 1 low, then the pattern has been invalidated.
Day 3: The price must remain above the established low. If the price moves below the Day 1 low, then the pattern has been invalidated.
Days 4 - 7: Follow-through day must occur, with a gain greater than 1.7%, heavier volume than the previous day and heavier volume than average.
Traders often make the mistake believing that they can accurately forecast the future. A better approach might be to create a trading plan by keeping several scenarios. Define your risk parameters and pain thresholds, the potential reaction to developments under each scenario and act accordingly to the trading plan.

These markets are potentially treacherous. Under these conditions it especially pays to have a plan ahead of time.

Disclosure: Long TNA

Monday, June 29, 2015

Time to buy GREK?

With Greece in turmoil and the Athens Stock Exchange closed, one of the few ways investors can get exposure to Greek stocks is through the Global X FTSE Greece 20 ETF (GREK), in addition to a number of listed ADRs.

As of the close on Monday, GREK was down 20% from Friday's close. Does this mean that speculators should step up and buy GREK in anticipation of a likely "Yes" vote in the upcoming referendum?

A quick glance at the chart gives us some good news-bad news readings. On one hand, the ETF did rally through a downtrend and the price has start to stabilize and go sideways, which is constructive. On the other hand, it did break support today on high volume, which is a bad sign.

Decomposing the portfolio
How about trying to value the ETF by looking at the components? My analysis of percentage holdings is based on Friday night's close, before the surprise referendum call and serves as a useful benchmark for valuation as that was the last time we had actual Athens Stock Exchange prices to compare against. The following table from Yahoo Finance, shows the top three holdings to be the local Coca-Cola bottler at roughly 20% weight, the local telecom at 10%, followed by the lottery operation at about 10%. While the first three holdings appear to have some stability and somewhat defensive in nature, the next few are banks, all of which have significant risk attached.

This table from Morningstar gives us some idea of the sector weightings and another overview of ETF holdings. Based on some quick back of the calculations, I get an estimated range of $6.57 to $7.56 per share.

Here`s how I did it. Consider a worst case scenario where the No side prevailed in the referendum and Grexit looms. I assume that the financials all get wiped out (24% weight), the Consumer Cyclical sector gets cut in half (18% weight) and everything else takes a 20% haircut. Based on Friday`s closing price of $11.78, that would give us a downside target of $6.57 per share.

A big bet on the banking sector
Monday`s closing price was only 20% below Friday`s level and the financial sector represented roughly 24% of the value of GREK. Therefore the current valuation of the ETF, which is blind because there are no market prices of the underlying share in Athens, is based on the dubious assumption that the banking sector won`t get wiped out.

Yves Smith at Naked Capitalism has the details of what might happen if and when Greece defaults:
In any case, enough about the past, let’s run through the most likely end game for this Greek saga as a deal never gets agreed before default.

1. Greece misses its IMF payment on the 30th of June. This could be a trigger but it may not be. The IMF has 30 days to call Greece in arrears so technically Greek government guaranteed collateral, and hence the Greek banks, are still solvent after the 30th. However on the 20th of July the Greeks will surely default to the ECB without a deal. This is the official d day.

2. Upon default, the collateral at Greek banks cannot be posted any longer to the Euro system. The Greek banks then become insolvent and the ECB, through the newly created Single Resolution Mechanism (SRM), is obligated to resolve the Greek banks.

3. So the ECB goes to Tsipras and tells him – we are immediately instituting capital controls and we will begin resolution of your banks unless u sign the agreement and re-enter a program. Without a bailout program in place the Greek government, and banking system, are both insolvent. So Tsipras says – what do you mean resolve my banking system? And then Mario explains as follows. First we wipe out all equity and bond holders. And then, as in Cyprus, we bail in depositors. There are 130b in Greek deposits against 90b in ELA. And while those deposits are technically insured up to 100,000 euro, there is no pan European bank insurance yet in place. That only comes in 2016. Right now Greek deposits are only insured with a Greek deposit insurance fund that has about 3b in it. This Is hardly enough for the 130b in deposits. So we take the 130b against the 90b in ela. Any remaining deposits go to fund a bad bank that begins resolving all the NPLs. The good loans of course will go into a good bank which will be funded with German capital and most likely will have a German name. Of course depositors will get 2 to 3 euro cents on the dollar for their existing balances from the 3bio in the insurance fund. So you have that going for you!
The big question then becomes, "When does the ECB decide to blow up the banking system, where the bank shareholders get wiped out and depositors recover 2-3 cents on the euro?"

Even the optimistic case looks ugly
Let`s construct a best case scenario. Suppose that the Yes side wins the referendum. Will all be forgiven and will Greece re-enter a bailout program and the banking system gets revived?

Not so fast! When Greece asked for a last minute extension to the bailout program so that it could wait for the results of the referendum, what upset the Eurogroup ministers was not just the surprise referendum call, but that the Tsipras government would be actively campaigning for the No side. Notwithstanding the fact that the Eurogroup offer expired on June 30, the active campaign for No by the Greek government made the Syriza government an unreliable partner in the Eurogroup`s eyes. How can such an organization be expected to implement any reforms that may have been agreed to. A Yes vote will likely cause the current Greek government to collapse and new elections called. Prime Minister Tsipras has indicated that he would resign should the Yes side prevail in a TV interview on Monday night (via CNN):
"If the Greek people want to move ahead with austerity ... for young people to move abroad in their thousands, for us to have unemployment and for us again to be moving towards new programs, new loans... if that is their choice we will respect it, but we will not carry it out," he said in an interview with Greek TV.

"I am telling you that I cannot be a prime minister under all circumstances."
While I could envisage a scenario where the IMF and ECB bent over backwards to keep supporting Greece and its banking system in the run-up to the referendum, there are some real drop-dead deadlines. There is a payment to the ECB on July 24 and, if Christine Lagarde is willing, there is a 30-day grace period for the missed payment to the IMF on June 30.

If we were to get a Yes vote, which is likely given current polling, and the Syriza government were to collapse. It is unclear whether there would be enough time to call new elections, form a new government and see the new government agree to a new bailout program before the July 24 ECB payment deadline. While the ECB could conceivably bend the rules and keep the banking system going at the current ELA levels until July 24, there would be no justification to do so if a payment to the ECB is missed. The ECB has no choice other than to resolve the banking system,

There are two groups in Greece who would get badly hurt under that scenario. Ordinary citizens who do not have the means or sophistication to move their money abroad and businesses with operating accounts with daily cash flows. Both would collapse and so would the Greek economy. Business collapses have cascading effects that cannot be reversed immediately.

Under such a seemingly *ahem* "optimistic scenario", bank shareholders would still get wiped out. So assume that GREK takes a 24% haircut on its position in financials and a 20% haircut on everything else, we get a target price of $7.56 based on the Friday close of $11.78.

In conclusion, the Monday closing price of GREK of $9.42 is well above my target range and Mr. Market is making a bet that the banking system remains intact. I am not willing to make such a courageous assumption.

Sunday, June 28, 2015

A study in volatility: Chillax, or sell everything?

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bearish

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

A bet on volatility
After the posts that I had written in the last week, where I examined the bull and bear case for stocks (see And now for something completely different: The Hegelian Dialectic) and a discussion of the possible causes of the current low equity volatility environment (see Will the quants blow up the market again?), I realized that I should be approaching the market in a different way. Instead of trying to forecast market direction, I should be trying to forecast the volatility regime.

As the chart below shows, US equities have been in a very tight trading range for all of 2015. As of the close Friday, the SPX was up a whopping 2% from year-end, with lots and lots of whipsaws. As an indication of the choppy market, I have marked with arrows the extraordinary number of instances the SPX has crossed its 50 day moving average. Further, the top panel shows the RSI(14) indicator, which is an overbought/oversold measure. This indicator has not flashed an overbought (over 70) or oversold reading (under 30) all year. In fact, it has stayed in a range even tighter than the more traditional 30-70 upper and lower bounds.

Think scenarios, not just direction
These are the characteristics of a low volatility equity market environment. Though volatility has spike in other markets, such as the fixed income and foreign markets, the realized vol of US stocks remains low. The key question then becomes, "Will this continue?"

When trying to forecast volatility, it is helpful to think about scenarios, one where volatility stays low and another where it breaks out.

On one hand, macro risks are high as the weekend ends, with Greece on the verge of default and the Chinese stock market on the verge of meltdown, which argues for a breakout in volatility and the start of a correction. On the other hand, the US macro and fundamental outlook has been improving, which is supportive of a rebound in stock prices.

The US bull case
Since the main focus is the direction of US equities, let us begin by assessing the US outlook. As an overview, the Atlanta Fed Nowcast of 2Q GDP growth has advanced to 2.1%, which is a significant improvement of 0.7% seen in mid-May.

Last week also saw better than expected retail sales data. As New Deal democrat pointed out, this represents unambiguous good news. The American consumer is back and spending.

The latest earnings outlook update from John Butters of Factset also brought good news. Forward EPS continues to advance and, as the chart below shows, forward EPS estimates have been highly correlated with stock prices (annotations in red are mine).

What about Greece? Butters showed that Greece was not mentioned in a single earnings call. In fact, eurozone countries were far down the list mentioned as issues in company earnings calls, which indicate that a Greek default or Grexit has little direct contagion effect on US corporate earnings.

From a technical perspective, here are the charts of the US and major European averages on Friday after the close, but before the news of a Greek referendum hit the tape. The Euro STOXX 50 had been rallying and testing its 50 dma, which is an indication that the eurozone is weathering the Greek crisis well. The UK FTSE 100 could also be construed as being in turnaround mode.

Bottom line: The Trend Model was on the verge of a trading buy signal. Even minor improvements in stock prices in the US and Europe would have moved the needle to bullish. Based on this analysis, US equities have room to rally in the absence of tail-risk.

As US stock prices have descended last week, such a bullish interpretation translates to a rally and therefore a likely continuation of the low volatility regime, where stock prices rise but get capped by other factors.

Chaccident and Graccident risks
As investors are well aware, the world is not without risks. The two immediate tail-risks that face the markets come from China and Greece.

The Shanghai market nosedived 7.4% on Friday and it is now down over 20% on a peak-to-trough basis, which puts it into bear market territory. The development was not a surprise (at least to me) as there have been reports of widespread insider selling. The stock indices of the regional exchanges of China`s major Asian trading partners staged rallies last week, but all were unable to break through their 50 dma, which would be indications of renewed strength.

The bearish and high volatility implication of these charts is that Mr. Market remains concerned about the outlook for Chinese growth. Should the Chinese stock market implode further, we could see a leakage of financial contagion spread throughout the region.

On the other hand, the PBoC reacted by cutting interest rates (via Bloomberg):
In the fourth reduction since November, the one-year lending rate will be reduced by 25 basis points to 4.85 percent effective June 28, the People’s Bank of China said on its website Saturday. The one-year deposit rate will fall by 25 basis points to 2 percent, while reserve ratios for some lenders including city commercial and rural commercial banks will be cut by 50 basis points, according to the statement.
The bullish interpretation is that the PBoC has reached its pain threshold and it is acting. A rally in the Chinese and regional markets are supportive of a continuation of the mean reverting low volatility environment of 2015.

Greece: Acropolis Now?
After the market closed on Friday, Greek PM Tsipras shocked the world (and his own negotiating team in Brussels) by announcing that he would be calling a referendum on July 5 to put the latest eurozone proposals to a vote. There are a number of problems with that course of action.
  1. The European bailout program of Greece expires on June 30 and the negotiations were centered on what the conditions are for an extension. The Eurogroup meeting on Saturday rejected a Greek request for an extension of the program. Extensions are subject to approval by the parliaments and legislatures of member EU states it appears that the member states were unwilling to expend the political capital to get an extension with such an uncertain return.
  2. Greece is scheduled to pay the IMF €1.6 billion on June 30, money which it wouldn't have without the bailout.
  3. It is unclear what the Greeks will be voting on in their July 5 referendum, as the extension offer expired on June 30 - a point that was confirmed by IMF chief Christine Lagarde to the BBC, though she did not completely close the door to the resurrection of the offer in the event of a "Yes" vote.
  4. As Greece will no longer in a bailout program after June 30, the ECB will have no choice but to terminate its ELA assistance to the Greek banking system. The banking system will implode and depositors will get 2-3 cents on the euro (for further details see my discussion last week And now for something completely different: The Hegelian Dialectic). As the news of the referendum spread on Saturday morning, there were widespread reports of lines at ATMs in Greece. A bank run has begun.
  5. On Sunday, the ECB has capped their Emergency Loan Assistance (ELA), which is the rough equivalent of the Fed window, to the Greek banking system at last Friday's level. In response, the the Greek government has imposed a bank holiday and capital controls.
The last point is of immediate concern for the financial markets. It means, at the very least, capital controls and, at worst, the vaporization of the Greek banking system. Yves Smith at Naked Capitalism faults both sides and calls the creditors "known thugs", but she believes that the referendum is a sham and a political fig leaf for Tsipras' failures in negotiation, leadership and governing:
So the only conceivable excuse for waiting this long is for Tsipras to attempt to save himself. If he were to reject the bailout, the decision is unquestionably his and that of his allies. That it precisely the sort of decision that government leaders are expected to make. Or he could just as well accept the bailout, recognizing that as bad as things are, that the country would be plunged into an even deeper economic sinkhole, putting the survival of even more citizens at risk. It would take forming a new coalition with To Potami and New Democracy, and that would mean that his and Syriza’s position would become far more tenuous and he would be fiercely denounced by many if mot most Syriza MPs.

Thus the referendum ruse looks to be about trying to spare Tsipras and Syriza the worst consequences of his having underestimated the creditors and not preparing for worst-case scenarios, which is another responsibility of leadership that he and his party have neglected.
Sounds dire? Is this the start of a market crash?

Consider the flip side of the coin. These risks have been well recognized for months and Bloomberg reports that contagion hadn't spread to other peripheral eurozone countries, though this report was penned before the referendum news (emphasis added):
Those warnings hadn’t thus far sparked a panic among bondholders.

Spain’s 10-year bond yield fell 16 basis points, or 0.16 percentage point, this week to 2.11 percent as of 5 p.m. London time on Friday, the steepest decline since Feb. 27. The 1.6 percent security due in April 2025 rose 1.395, or 13.95 euros per 1,000-euro ($1,115) face amount, to 95.51.

And although talks between Greece and its creditors had whipped up intraday volatility, the yield difference, or spread, between Spanish and German 10-year securities, seen as a marker of investors’ demand for safer assets, narrowed. It decreased to 119 basis points on Friday, from 152 basis points at the end of last week.

The spread widened to as much as 650 basis points in July 2012, when contagion from the region’s debt crisis that had its epicenter in Greece threatened to break up the currency bloc.

“The logic is that if a Grexit is postponed then contagion is less of a problem, so that goes to the benefit of Spain and the rest,” Marius Daheim, a senior rates strategist at SEB AB in Frankfurt, said before the referendum was announced. “But these are news-driven short-term moves which could reverse if something goes wrong.”

The yield on Italian 10-year bonds fell 13 basis points to 2.15 percent this week, the biggest drop since March.
A report from Deutsche Bank (via FT Alphaville) showed that Greek contagion is far more ring-fenced that it was in 2012. In particular, the second chart (figure 11) hints at the ECB turning on the QE and OMT taps to counteract any Greek contagion effects.

Indeed, the latest ECB statement on capping Greek ELA at current levels ended with this ”whatever it takes” paragraph (emphasis added):
The Governing Council is closely monitoring the situation in financial markets and the potential implications for the monetary policy stance and for the balance of risks to price stability in the euro area. The Governing Council is determined to use all the instruments available within its mandate.
While history doesn't repeat itself, it does rhyme and we can also look to the Cypriot crisis as a guide as to what might happen next. As the chart below shows, the farther a region was from the epicenter of the crisis, the more insulated the market was. US equities (top panel) didn't respond at all to the imposition of Cypriot capital controls and the resolution of its banking system. Greece was the most exposed (see bottom panel) and Europe (top panel) was somewhere in the middle.

As the Cypriot capital control episode showed, the Greek and European markets fell initially on the news and bottomed soon afterwards. US markets barely reacted at all. The Cyprus example suggests that volatility will likely breakout, but in the form of upside volatility.

One last thing. Reuters reports that the latest polls indicated that the majority of Greeks want a deal:
A majority of Greeks favor accepting a bailout deal with international lenders, according to two opinion polls conducted before Prime Minister Alexis Tsipras announced a surprise referendum on the issue.

The survey by the Alco polling institute published in Sunday's edition of the Proto Thema newspaper, said 57 percent of 1,000 respondents were in favor of reaching a deal, while 29 percent wanted a break with creditors.
A second poll also showed similar results and Ladbrokes is quoting odds of 1/3 for a "Yes" referendum vote and 2/1 for a "No" vote.
Pollsters Kapa Research said 47.2 percent of respondents were in favor of an accord and 33 percent against, according to To Vima newspaper. Its 1,005 respondents were asked how they would vote if a new "painful" agreement were put to the vote in a referendum.

Some 48.3 percent of respondents in the Kapa poll said they would not support any move by the government which could place Greece outside the euro zone.
These sets of analysis argue for a rally after any initial market decline, which would be a continuation of the up-and-down low volatility environment that we have been seeing for all of 2015.

The week ahead: Watching and waiting
Here is how I am approaching the holiday shortened week ahead. First of all, I would like to give my wishes in advance all my Canadian friends for Canada Day (July 1) and all my American friends for Independence Day (July 4).

My inner investor is watching all this macro drama in a somewhat bemused fashion. The fundamentals for US equities are improving and downdraft constitutes a summer sale on stocks that he would be happy to participate in.

My inner trader, on the other hand, is approaching the week by watching and waiting to see how the volatility scenarios are developing. He profited last week from what was in essence a bet on a low volatility regime by:
All of those trades were profitable. On Friday, he dipped his toe in on the long side on the basis of a bet on a low volatility range-bound market, the news that Greece was inches away from a deal, the "oversold" readings of the market by 2015 standards:

,,,and a longer term analysis indicating that the NYSE Summation Index (bottom panel) and NYSE common stock only Summation Index (middle panel) were turning up. These readings are highly suggestive that the bulls will see tailwinds for the next few weeks.

As my inner trader watches the event-driven volatility in the week ahead, he will keep his position commitments light. He will evaluate the market action using the framework of the two possible volatility regimes as well as his own risk control parameters. Will we see SPX RSI(14) break out, either on the upside or downside? If SPX were to sell off hard, will it break the key support level of the 150 dma at 2078, which has put a floor on the market for the last couple of years?

As I write these words, equity futures are deep in the red, but Sunday night futures markets have a way of changing dramatically by Monday's open. Next week`s market will be full of twists and turns (and I haven`t even mentioned the US Employment report Thursday). Should you chillax, or panic and sell everything?

The market will not seem so chaotic as long as you have a plan. Keep commitments light, define how much risk you want to take and don't go overboard on your positions. Good luck.

Disclosure: Long TNA

Thursday, June 25, 2015

Are HFTs responsible for low market volatility?

I received a number of thoughtful responses from last post about falling equity volatility (see Will the quants blow up the markets again?). One of the themes that was repeated several times in the comments pointed to HFT algos as a possible culprit for the low volatility regime.

On the surface, the HFT explanation does make sense. HFTs are supposed to provide liquidity to the market during "normal" markets (and the current market regime is "normal"). Bloomberg reported that a study on HFT behavior based on Norway`s SWF trading activity and found that, in aggregate, HFT algos were providing liquidity to orders and not front-running them (emphasis added):
High-frequency traders are more prone to first go against the flow of orders by large institutions, according to a study based on trade data provided by investors including Norway’s $890 billion wealth fund.

The study found that HFTs “lean against the order” in the first hour and then turn around and go with the flow in the case of multi-hour trades, the study by University of Amsterdam professors Vincent van Kervel and Albert J. Menkveld released Thursday showed. Trading costs are 39 percent lower when the HFTs lean against the order, “by one standard deviation,” and 64 percent higher when they go with it, they said.

“The results are inconsistent with ‘front-running’ in the sense of HFTs who detect a large, long-lasting order right from the start and trade along with it,” van Kervel and Menkveld said. “We speculate that HFTs eventually feel the imbalance caused by it. In response, they trade out of their position as they understand that leaning against such order as a market maker requires a long-lasting inventory position. HFTs prefer to be flat at the end of the day.”

How fat are the tails?
Another way of thinking about market volatility is to see if stock returns have fat-tails. One statistical measure is kurtosis, which is explained this way:
Having discussed the shape of a normal distribution, we can talk about kurtosis and what it means to have fat tails and peakedness. The total area under a curve is by definition equal to one.

With that in mind, think about what having fatter tails might mean. If you were to think of a curve having three parts (all imaginary) – the peak, the shoulder (or the middle part), and the tails, you can imagine what happens if you stretch the peak up. That reduces variance, and probably sucks in ‘mass’ from the shoulders. But in order to keep the variance the same, the tails rise higher, increasing variance and also providing fatter tails.

Fat tails would imply there is more area under the tails, which means something else has to reduce elsewhere – which means that the ‘shoulders’ shrink making the peak taller. In order to compare kurtosis between two curves, both must have the same variance. At the risk of being repetitive, note that the variance has an impact on the shape of a curve, in that the greater the variance the more spread out the curve is. When we say that kurtosis is relevant only when comparing to another curve with identical variance, it means that kurtosis measures something other than variance.

For the non-geeks, here is how you interpret kurtosis. A standard normal distribution has a kurtosis of 0 and fat-tailed distributions have positive kurtosis.

Here is a chart of the rolling one-year kurtosis of daily SPX returns going back to 1990. First, the median kurtosis is 1.34, indicating that stock returns have fatter tails than a typical normal distribution (and option traders using the Black-Scholes model, which is based on a normal distribution, know that fact well). As well, kurtosis has been falling since 2011, indicating that the tails are getting thinner. This is not unusual as there has been episodes in the past when kurtosis has been even lower than they are today.

If HFTs are coming into the market and providing liquidity by buying the dips and selling the rips at a micro level, then we should expect kurtosis to fall.

An HFT Bataan death march?
The hypothesis that HFT algos were the cause of the low volatility environment is intuitively attractive from a data standpoint, but illogical from a business viewpoint. That's because HFT profitability has been tanking for the last several years. This Bloomberg story from 2013 (two years ago) show how HFT industry profitability has cratered over the years:
According to Rosenblatt, in 2009 the entire HFT industry made around $5 billion trading stocks. Last year it made closer to $1 billion. By comparison, JPMorgan Chase (JPM) earned more than six times that in the first quarter of this year. The “profits have collapsed,” says Mark Gorton, the founder of Tower Research Capital, one of the largest and fastest high-frequency trading firms. “The easy money’s gone. We’re doing more things better than ever before and making less money doing it.”

“The margins on trades have gotten to the point where it’s not even paying the bills for a lot of firms,” says Raj Fernando, chief executive officer and founder of Chopper Trading, a large firm in Chicago that uses high-frequency strategies. “No one’s laughing while running to the bank now, that’s for sure.” A number of high-frequency shops have shut down in the past year. According to Fernando, many asked Chopper to buy them before going out of business. He declined in every instance.
This slide from an HFT presentation in 2014 tells the same story (annotations in purple are mine):

Given how industry margins has fallen over the years and the reports of diminishing HFT profitability came out in 2013, it would be illogical for the industry to engage in a further arms race to drive down volatility further. Such an act would amount to a Bataan death march for HFT.

Based on this analysis, HFT algos may have contributed to the decline in equity volatility since 2011, but I cannot conclude that they were the main culprits. The mystery of equity market volatility compression still remains a mystery.

Tuesday, June 23, 2015

Will the quants blow up the markets again?

Josh Brown had a fascinating post which postulated that the quants pose a significant systemic risk to market volatility:
There’s an interesting idea going around that asset management – specifically the metastasizing quantitative strategies run via black box are where the next big scare is due to come out of. Volatility has been so low, for so long, that winning trades have become crowded and leverage is bountiful. And the kicker – they’re all running the same playbook, loading up in the same trades.
Josh referred to a post by Dominique Dassault at Global Slant and he drew the conclusion that it may all collapse as it did in 2008:
Dassault, in referring to “ten years ago”, is referencing the subject of Scott Patterson’s excellent book, The Quants, in which a handful of genius mathematicians were blown up in a 2006 incident which presaged the global market meltdown that would begin a year later.
I think that Josh missed the point. The incident that Dassault referred to was not the crash of 2008, in which quants made erroneous assumptions about their model inputs (house prices don't fall). Instead, she was referencing a little known quant meltdown that which occurred in August 2007 in which equity quants got into a crowded trade when someone tried to liquidate - in size. I wrote about this episode before (see Are quants the victims of their own success?). The chart below shows the HFRX Equity Market Neutral Index (in blue) and a different strategy (in red) that I was involved in which used some very different factors that did not land us in the crowded long.

From discussions with former colleagues and other equity quants at the time, the meltdown was very ugly. Long-only quantitative accounts with relatively low turnover portfolios suddenly saw relative performance tank to -10% to -15% against their benchmarks in a matter of days, as per the above chart. Moreover, factors that were uncorrelated by design, e.g. value vs. growth, all suddenly saw their return correlations converge to 1.

How models blow up
Dassault explained the fatal design flaw of these models in her blog. She had been interviewing with a leading hedge fund manager about 10 years ago who expressed concerns about the stability of quant models:
While in Greenwich Ct. one afternoon I will never forget a conversation I had with a leading quantitative portfolio manager. He said to me that despite its obvious attributes “Black Box” trading was very tricky. The algorithms may work for a while [even a very long while] and then, inexplicably, they’ll just completely “BLOW-UP”. To him the most important component to quantitative trading was not the creation of a good model. To him, amazingly, that was a challenge but not especially difficult. The real challenge, for him, was to “sniff out” the degrading model prior to its inevitable “BLOW-UP”. And I quote his humble, resolute observation “because, you know, eventually they ALL blow-up“…as most did in August 2007.

It was a “who’s who” of legendary hedge fund firms that had assembled “crack” teams of “Black Box” modelers: Citadel, Renaissance, DE Shaw, Tudor, Atticus, Harbinger and so many Tiger “cubs” including Tontine [not all strictly quantitative but, at least, dedicated to the intellectual dogma]…all preceded by Amaranth in 2006 and the legendary Long Term Capital Management’s [“picking up pennies in front of a steam-roller“] demise one decade earlier.
My circle of quants at the time of the August 2007 were not the Citadels and DE Shaws, but traditional long-only quant shops around Boston like SSgA, GMO and so on. The results were the same. Everyone blew up.

At the time, most of the equity quants more or less had the same approach to modeling, though the details of the models were different. They were multi-factor models with a little bit of growth, a little bit of value, sprinkle in some momentum (fundamental in the form of estimate revision and earnings surprise), technical in the form of PRICE momentum, usually some form of relative strength with a one-month price reversal. They might toss in other exotic ingredients like insider trading activity or buybacks. These multi-factor models used uncorrelated factors by design, so that when you combined them, they were supposed to give you a stable alpha.

Then they overlaid extensive risk control. Dassault explains what she saw at her hedge fund:
First of all, a large number of variables in the stock selection filter meaningfully narrowed the opportunity set…meaning, usually, not enough tickers were regularly generated [through the filter] to absorb enough capital to tilt the performance meter at most large hedge funds…as position size was very limited [1-2% maximum]. The leaders wanted the model to be the hero not just a handful of stocks. So the variables had to be reduced and optimized. Seemingly redundant indicators [for the filter] were re-tested and “tossed” and, as expected, the reduced variables increased the population set of tickers…but it also ramped the incremental volatility…which was considered very bad. In order to re-dampen the volatility capital limits on portfolio slant and sector concentration, were initiated. Sometimes market neutral but usually never more than net 30% exposure in one direction and most sectors could never comprise more than 5% of the entire portfolio. We used to joke that these portfolios were so neutered that it might be impossible for them to actually generate any meaningfully positive returns. At the time of “production” they actually did seem, at least as a model, “UN-BLOW-UP-ABLE” considering all the capital controls, counter correlations and redundancies.
As a general rule, hedge fund alphas tended to be shorter lived than long-only alphas, but everyone had portfolios risk controlled 18 ways to Sunday. Yet they all blew up in August 2007.

Andy Lo explains August 2007
Some time after that fateful month in August, Andrew Lo of MIT made an extensive study of the topic. A subsequent paper by Amir E. Khandani and Andrew W. Lo asked the question: What happened to the quants in August 2007? Evidence from factors and transactions data. Here is the abstract:
Using the simulated returns of long/short equity portfolios based on five valuation factors, we find evidence that the “Quant Meltdown” of August 2007 began in July and continued until the end of 2007. We simulate a high-frequency marketmaking strategy, which exhibited significant losses during the week of August 6, 2007, but was profitable before and after, suggesting that the dislocation was due to market-wide de-leveraging and a sudden withdrawal of marketmaking risk capital starting August 8. We identify two unwinds—one on August 1 starting at 10:45am and ending at 11:30am, and a second at the open on August 6, ending at 1:00pm—that began with stocks in the financial sector, long book-to-market, and short earnings momentum.
Earlier iterations of this research postulated a large seller coming to liquidate what amounted to a crowded trade, otherwise known as the Unwind Hypothesis. In other words, the majority of quants were in the same set of stocks despite the apparent diversity of their models:
This hypothesis suggests that the initial losses during the second week of August 2007 were due to the forced liquidation of one or more large equity market-neutral portfolios, primarily to raise cash or reduce leverage, and the subsequent price impact of this massive and sudden unwinding caused other similarly constructed portfolios to experience losses. These losses, in turn, caused other funds to deleverage their portfolios, yielding additional price impact that led to further losses, more deleveraging, and so on. As with Long Term Capital Management (LTCM) and other fixed-income arbitrage funds in August 1998, the deadly feedback loop of coordinated forced liquidations leading to deterioration of collateral value took hold during the second week of August 2007, ultimately resulting in the collapse of a number of quantitative equity market-neutral managers, and double-digit losses for many others.
Fast forward to today. Dassault postulates a crowded long by the fast money crowd and their positions and returns have been exaggerated by leverage. What`s more, the assets are concentrated in just a few very large funds:
What has changed though is the increased dollars managed by these funds [now $3.5T] and the concentration, of these dollars, at the twenty largest funds [top heavy for sure]. What has also considerably changed is the cost of money…aka leverage. It is just so much cheaper…and, of course, is still being liberally applied but, to reiterate, in fewer hands.
Add in a dash of excess conviction and hubris and you get a potential time bomb:
1. Strong Conviction…aka Over Confidence +
2. Low Volatility +
3. High Levels/Low Costs of Leverage [irrespective of Dodd-Frank] +
4. More Absolute Capital at Risk +
5. Increased Concentration of “At Risk” Capital +
6. “Doing the Same Thing”

…Adds up to a Combustible Market Cocktail.
She concluded [emphasis added]:
Still a catalyst is needed and, as always, the initial catalyst is liquidity [which typically results in a breakdown of historic correlations as the models begin to “knee-bend”…and the perceived safety of hedges is cast in doubt] followed by margin calls [the ugly side of leverage…not to mention a whole recent slew of ETF’s that are plainly levered to begin with that, with the use of borrowed money, morph into “super-levered” financial instruments] and concluding with the ever ugly human panic element [in this case the complete disregard for the “black box” models even after doubling/trebling capital applied on the way down because the “black box” instructed you to]. When the “box” eventually gets “kicked to the curb”…that is when the selling ends…but not after some REAL financial pain.

Spotting the crowded trade
So far, we just have a "this will not end well" story, but we have no idea of what the crowded trades are and what the trigger for an unwind might be. Here is where things get more speculative (and comments from anyone who is closer to the situation are invited).

One of the crowded trades are algos that suppress market volatility, either by design or as a side-effect. Bloomberg reported that 2% stock market moves have disappeared in 2015 and Business Insider reported that the market hasn't seen a 1% in eight straight weeks:

This kind of low realized vol environment has made stars of managers who run risky long-tailed strategies that pick up pennies in front of steamrollers. Consider, for example, this account about a fund which holds cash and sells put options on stocks that is being marketed as (*shudder*) a fixed-income alternative. The lack of recent downside equity market volatility has made this strategy a stellar performer and put up a return of 12.7%, triple the stock market.

In a separate post, Dassault calculated the risk-adjusted returns of holding US equities in early 2015 and the results were extraordinary (recall that the Sharpe ratio = (return - risk free rate)/volatility):
Recently I constructed a model that required one, three and five year Sharpe Ratios for the SP 500. I also decided to include the Sortino Ratio. Prior to the results I hypothesized that the numbers ought to be pretty impressive given the endless equity “bull” since March 2009 but I was still curious to get the exact data. Plus, a weekly price chart of the SP 500, since 2009, visually reflects the anomaly of very limited draw-downs in the context of extremely strong returns. The calculations are as follows and as Mrs. Doubtfire once said…“Effie…Brace Yourself”.

Sharpe Ratio
1 Year = 1.37
3 Year = 1.86
5 Year =1.0

Sortino Ratio
1 Year = 2.65
3 Year = 3.41
5 Year = 1.69

Collectively, these numbers are clearly impressive but even more so in that they are calculated from a passive, long only strategy. This is a hedge fund manager’s worst nightmare as, for five years, most “hedging” has proved to be only performance degrading.

Furthermore, the Sortino Ratio data are nothing short of staggering. What they really say = Plenty of Gain with Very Little Pain.…and it really is unsustainable if only because it has become much too easy to generate positive returns with very little effort, pain or savvy.
To put these extraordinary Sharpe Ratios into context, the long-term Sharpe Ratios realized by legendary investors like Buffett, Robertson and Soros were in the 0.7 to 1.1 range. Yet a simple buy-and-hold strategy yielded 1, 3 and 5 year figures better than these investment giants!

These results are highly suggestive that equity volatility has been artificially suppressed in some fashion (no it probably isn't the Fed as QE programs had been well under way for years before volatility dived), As Captain Kirk might say, “Someone, or some thing, is suppressing market volatility to make it seem that stocks are safer than they are.“ Which brings us back to the Josh Brown comment earlier:
There’s an interesting idea going around that asset management – specifically the metastasizing quantitative strategies run via black box are where the next big scare is due to come out of. Volatility has been so low, for so long, that winning trades have become crowded and leverage is bountiful. And the kicker – they’re all running the same playbook, loading up in the same trades.
Could the culprit for low vol be the black-box algos themselves? Another characteristic, or side-effect, of the low volatility environment is the stock market appreciated steadily without a 10% correction since 2011.

I have written about this theme many times before (see the Jim Paulsen study indicating the steady market uptrend is breeding complacency and my own work at Why I am bearish (what would change my mind)). But now, the steady uptrend is starting to crack.

This is the daily SPX chart. Note how the RSI indicator (top panel) has not flashed an overbought reading over 70 and oversold reading of below 30 in all of 2015. The VIX Index (bottom panel) has been steadily declining. Both of these indicators are signs of a compressed volatility environment. On the other hand, the uptrend is starting to labor as the SPX index is losing momentum and appears to be rolling over.

The longer term 20-year monthly chart shows that the MACD histogram fell to a negative reading in January 2015, rose briefly and fell back into negative territory in March. These are the typical signs of a loss of price momentum cited in the Paulsen study. Every past instance in the last 20 years has resolved themselves in bear phases.

If these "black box algos" have been suppressing volatility either as a side-effect or by design, but they need a steadily rising stock market to make money, then could these indications that these models are starting to “knee-bend“?

We can make an educated guess. An examination of the returns of the HFRX equity market neutral hedge fund index*, which is how many of these algo strategies would be classified (though there would be other equity market-neutral strategies in that index) shows that these strategies have been struggling in 2015 with flat returns, though returns were positive in 2013 and 2014. The evidence is tantalizing and suggestive, but not conclusive as returns were not exactly stellar in past years.

Don`t panic on an algo unwind!
If I am correct in my hypothesis that these algos are both suppressing equity volatility but require a steadily rising market to achieve returns, then the day of reckoning may be near.

The damage level depends on how crowded the trade is. If the trade isn't very crowded, then we may see a quick ”flash crash”, where these strategies blow up and the market returns to normal within a day or two. On the other hand, if the unwind becomes a ”margin clerk” market that requires a liquidation period of several weeks, then we may see a LTCM or 1987 style crash and snapback.

Should we encounter such market turbulence, my inner investor believes that the best thing to do is nothing. Even if we suffered the the worst case of a 1987 event, the market came back to normal within a few months. On the other hand, those who panicked and blinked got hurt very badly.

* Astute readers will ask why a market-neutral strategy requires market direction to make money. I was the analyst who initiated and wrote the BoAML Hedge Fund Monitor, in which we developed a heuristic to reverse engineer the betas of various hedge fund strategies. We found that despite the name, equity market-neutral strategies were generally not market neutral and took directional beta bets.

Sunday, June 21, 2015

And now for something completely different: The Hegelian Dialectic

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bearish

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

Hegelian Dialectic: Bull and bear debate
Regular readers know that I have been cautious on the US equity market for several months. Instead of re-hashing the same points over and over again, I thought that I would try something different this week. I will re-examine the bull and bear case for stocks in the framework of the Hegelian Dialectic of "thesis, antithesis and synthesis", otherwise known as "thinking outside the box".

Thesis: The bull case for stocks
New information has come to light recently that bolsters the bull case for equities:
  • Improving fundamentals
  • Sentiment readings are becoming bearish, which is contrarian bullish
  • Price strength in selected sectors, such as the all-time high achieved by the NASDAQ and Russell 2000, as an indicating of better price momentum
  • The high likelihood of a relief rally from a resolution of the Greek crisis (see Two ways to play Greece)
Let's go through each of those points, one at a time.

Better fundamentals
In the last few weeks, high frequency economic data has had a tendency to beat expectations, rather than disappoint as they've done for much of 2015. Rhe Citigroup Economic Surprise Index, shown below, is turning up, indicating an improving economic outlook. The Atlanta Fed GDPNow estimate of 2Q GDP growth has surged to 2.0% from a low of 0.7% in mid-May.

John Butters of Factset reported that consensus forward EPS estimates are growing in line with the better economic outlook. As the chart below shows, the change in forward EPS has been highly correlated with the direction of stock prices.

Sentiment getting too bearish?
In addition, sentiment models are getting more bearish. There was a lot of buzz generated early last week when the BoAML Fund Manager Survey (FMS) revealed that institutional managers had taken out a lot of tail-risk insurance, probably because of fears relating to  Greek tail-risk (more on that below).

The latest AAII survey also showed bullish sentiment to be very low on a historical basis, though Bespoke did point out that bearish sentiment also ticked up during the week as neutral sentiment retreated.

The latest II survey data also showed the bull-bear spread to have fallen to a new low for 2015:

NAAIM exposure has fallen to a 2015 low, which is also contrarian bullish.

The CNN Money Fear and Greed Index is also at depressed levels indicating rising bearishness.

Overall, these sentiment readings are suggestive of a crowded short and the formation of the proverbial wall of worry.

Technical strength + impending rally = ?
All these readings would be understandable if stock prices had taken a tumble, but that's hardly the case. The SPX fell about 3% on an intraday peak to trough basis but recovered late last week. In addition, several leading indices, such as the NASDAQ Composite and the Russell 2000, made all-time-highs.

In addition, I wrote last week that eurozone stocks and, in particular, Greek equities were no longer responsive to bad news from the Greek crisis, which indicated that they were poised for a relief rally. As the chart below of the Euro STOXX 50 indicates, eurozone stocks had been falling since April, but their uptrend from last September remains intact. 

The combination of the technical condition and skeptical psychology of the market leads me to believe that European stocks are likely to stage a significant relief rally once the Greek crisis is resolved - and it appears that a final resolution is highly likely next week. Given the high degree of correlation between US and European markets, a Greek inspired relief rally is likely to push US stocks higher as well.

Antithesis: The bear case
I have been writing about the bear case for so many weeks I am starting to sound like a broken record. The best summary can be found at my previous post Why I am bearish (and what would change my mind).

To make a long story short, the intermediate term bear case rests on a series of technical conditions that amount to more or less the same thing. Call you what you want, excessive complacency, deteriorating price momentum, uptrend violations - they all amount to the same thing. The monthly chart below illustrates my point (note that this is a monthly price chart and therefore daily squiggles don't matter very much). 

A 100% accuracy model in calling bear phases

The chart above has a 100% accuracy in calling bear phases in the last 20 years (N=5). Further analysis based on DJIA data going back to 1900 also came to the same conclusion. Whenever the MACD histogram (bottom panel) turns negative, the market is either in a bear phase (shown by the 12m rate of change in the top panel), or is about to enter into a bear phase. We saw MACD turn briefly negative in January 2015, tick back to positive in February, followed by relapse into negative and deteriorating MACD readings in starting in March 2015.

The intermediate term bearish argument is also supported by deteriorating breadth and other internals. This chart from IndexIndicators showed the % of SPX stocks above their 50 dma have been steadily declining. On Thursday, when the SPX rallied about its 50 day moving average on Thursday, the percentage of stocks in the SPX above its 50 dma was barely above 50% at a 53.8% reading. Taken together, that`s not a picture of strong breadth.

At the end of the week, much of the technical conditions that prevailed for much of 2015 was unchanged. The market remains in a tight trading range, with the RSI(14) indicator (second panel) staying highly range-bound, having refused to get either overbought or oversold all year. The shorter term RSI(5) indicator (top panel) reversed off an overbought reading on Friday, however, which is bearish on a 2-3 day time frame basis.

Intermediate term technical conditions continued to deteriorate. The equal to float weighted SPX ratio (green line, third panel) has been falling, indicating a negative breadth divergence. In addition, the relative price performance of HY bonds to equivalent duration Treasuries (bottom panel) has been rolling over and creates concerns about the quality of global risk appetite. 

There has also been a lot of recent discussion about weakness in the DJ Transports as a non-confirmation of the new highs in the DJ Industrials, which is a Dow Theory concern. Dana Lyons showed that not only are the Transports weak, the DJ Utilities are weak. Such conditions have tended to resolve themselves bearishly in the past.

Global risk appetite, which is what the Trend Model is measuring, is also a concern for stock prices. The UK FTSE 100 (not shown) is now under both its 50 and 200 dma. In addition, the Shanghai Composite has now fallen over 10% on a peak-to-trough basis and under its 50 dma, which puts it into correction territory. The chart below shows not only the Shanghai Composite, but the indices of Greater China, or China's major trading partners (except for Japan, which has its own issues). All of the regional bourses are struggling technically and several (Taiwan and Singapore) have violated their 200 dma, which is used to delineate bull and bear markets.

The technical difficulty of the stock markets of China's major trading partners illustrate the point that China has become an increasingly important part of the global economy. A report from Business Insider shows how Chinese imports have exploded over the last few years.

The number of countries that count China as its top trading partner has been steadily rising and now number 43. A Chinese slowdown would therefore have a much greater impact on the global economy than at the time of the Lehman Crisis in 2008, when the count was only 12.

China is the biggest marginal consumer of many commodities and the global growth signals from commodity prices is disappointing. The chart below shows the price of industrial metals (top panel) and the CRB Index (second panel) and the USD Index (bottom panel). I have also shown the cyclically sensitive industrial metals in euros and Australian Dollars. The key takeaway here is commodity prices are weak, regardless of currency. In particular, the recent decline in commodities in the face of a falling USD, which tends to be inversely correlated to commodities, is a warning sign that of weakening global demand, especially from China.

In conclusion, the combination of weak price momentum, deteriorating breadth and poor global risk appetite are all intermediate term bearish signs for US equities.

Rising earnings? Not so fast!
I recognize that the improving economy and rising EPS estimates is likely to provide a tailwind for equity bulls. However, Jim Paulsen at Wells Capital Management has a dissenting viewpoint. Paulsen wrote in his June letter that he was worried about margin pressures cutting into earnings growth. He observed that US corporate margins appeared to have reached a plateau:

...and unemployment is falling, which creates wage pressure and therefore squeeze margins. Historically, corporate profits have struggled once the unemployment rate reached the current level of 5.5%.

Paulsen also raised concerns about the effects of Fed tightening on the profit cycle. In the past, stock prices have continued to rise when the Fed started tightening "because the profit cycle is usually still in the early stages of recovering from the previous recession", but not this time [emphasis added]:
Of the many unique aspects characterizing contemporary monetary policy, one which may prove very important for the stock market is “how long” the Fed has waited to begin the tightening process. Our concern is not that by waiting so long, the Fed is behind the curve (although that also is possible). Rather, by waiting too long to start the process, the Fed has allowed its traditional exit ramp (i.e., raising interest rates against strong gains in corporate profits) to expire. Consequently, the Fed is now about to begin the process of raising interest rates without its traditional buffer of recovering profitability.
Jim Paulsen is no permabear and his views add a fresh perspective on the macro outlook for equities. He has been increasingly cautious on the stock market and his views should be given due consideration.

Sentiment: What fear really looks like
I also want to address the issues raised by apparent bearish sentiment readings. The US equity market has not seen a 10% correction since 2011, so many investors and traders may not really remember what real fear looks like. So if we were to accept the premise that the stock market appears to be vulnerable intermediate term, a wimpy 3% pullback is unlikely to create the kinds of sentiment backdrop for a durable bottom.

Let's take a look at what real fear has looked like in the past. Here is a 10-year chart of the AAII Bear to Bull ratio (in black) and the Rydex bear fund+money market to bull fund cash flow ratio (in green). True, bearish sentiment readings have spiked, but they are only slightly in the bearish side of neutral and nowhere near the extreme bearish readings seen at past market bottoms (marked by vertical lines). The same comment could be made about the AAII data.

Here is a chart of the VIX-VXV ratio, which measures the term structure of the VIX Index. When the ratio is above 1, it indicates backwardation in the term structure and a high level of fear in the market. Current readings can only be characterized as neutral and nowhere near the extreme fear readings seen at past market bottoms.

The NAAIM exposure readings appear ominous, but in reality they can only be characterized as neutral and not at a bearish extreme. I have indicated with circles what real fear has looked like in the past. 

One last thing, if everyone is so bearish on stocks, why did Lipper report that investors pulled $5.2b out of taxable bond funds and pour $6.9b into equity funds, with a $4.5b lion's share going into US equities?

Greece: Faites vox jeux
The key to the bull-bear debate in the short-term rests with Greece and how that crisis gets resolved. After many, many so-called "deadlines", it is finally crunch time for Greece and the crisis will likely get resolved next week, one way or the other. An emergency summit has been called for Monday in which Athens will undoubtedly be given a take-it-or-leave-it ultimatum. There are three scenarios to consider:
  1. Someone blinks and there is a deal. Even if it's an incomplete kick-the-can-down-the-road solution, we can pretty much expect that the markets will stage a relief rally. 
  2. Greece defaults but stays in the euro. We can look the Cypriot episode as a template of what might happen next. When the Cypriot banking system unexpectedly melted down, the authorities were able to contain the damage to the eurozone financial system and equity market downside was limited. Stocks rallied soon afterwards.
  3. Greece defaults and leaves the euro. This is highly unlikely. The Europeans don't want to kick Greece out and the Syriza controlled Greek government does not appear to be operationally prepared to leave the euro (see this discussion about what's involved at Naked Capitalism). It took years of preparation to transition from national currencies to the euro and such a change can't be done overnight without causing total chaos. I don't find Grexit to be a credible threat for the immediate future.
As an aside, I have written before that the problems that Greece faces are intractable and the solutions advocated by each side only addresses part of the problem (see What would happen after a "Speech of Hope"?). I am not here to make moral judgments, but to ascertain what the likely trajectory of the European markets will be next week. Consider the alternatives. Option 1 is obvious, the markets rally. Option 3 is unlikely for the reasons I outlined, so let's explore what happens with the discussions leading up to option 2.

Yves Smith at Naked Capitalism provided a useful synopsis of how such a scenario might play out. It has been said that the euro was a flawed monetary union from the beginning and the strains might even lead to war. Indeed, we are seeing a form of war as the Europeans have very effectively weaponized the financial system. Smith highlighted analysis from David Zervos of Jeffries of how it might all play out over the next few days [emphasis and comments added]:
1. Greece misses its IMF payment on the 30th of June. This could be a trigger but it may not be. The IMF has 30 days to call Greece in arrears so technically Greek government guaranteed collateral, and hence the Greek banks, are still solvent after the 30th. However on the 20th of July the Greeks will surely default to the ECB without a deal. This is the official d day.

2. Upon default, the collateral at Greek banks cannot be posted any longer to the Euro system. The Greek banks then become insolvent and the ECB, through the newly created Single Resolution Mechanism (SRM), is obligated to resolve the Greek banks. [Cam: Klaus Regling of the European Stability Mechanism has stated that their loans are linked to the IMF and a default to the IMF is a default to ESM.]

3. So the ECB goes to Tsipras and tells him – we are immediately instituting capital controls [Cam: Actually the decision to impose capital controls is up to the member state and not the ECB, but that's only a minor detail] and we will begin resolution of your banks unless u sign the agreement and re-enter a program. Without a bailout program in place the Greek government, and banking system, are both insolvent. So Tsipras says – what do you mean resolve my banking system? And then Mario explains as follows. First we wipe out all equity and bond holders. And then, as in Cyprus, we bail in depositors. There are 130b in Greek deposits against 90b in ELA. And while those deposits are technically insured up to 100,000 euro, there is no pan European bank insurance yet in place. That only comes in 2016. Right now Greek deposits are only insured with a Greek deposit insurance fund that has about 3b in it. This Is hardly enough for the 130b in deposits. So we take the 130b against the 90b in ela. Any remaining deposits go to fund a bad bank that begins resolving all the NPLs. The good loans of course will go into a good bank which will be funded with German capital and most likely will have a German name. Of course depositors will get 2 to 3 euro cents on the dollar for their existing balances from the 3bio in the insurance fund. So you have that going for you!

4. Tsipras hyperventilates and quickly reaches for a bottle of ouzo.

5. Then it’s basically time for the gallows. He either signs a document cutting pensions, raising VAT and violating all his red lines. Or he takes the Greek people into bankruptcy and out of the euro. Either way he is a dead man. His own party destroys him if he does the former [Cam: and his wife leaves him]. And the 70 percent of Greek who want to stay in the euro destroy him if he does the latter. Of course there is one other choice for Tsipras. He could just resign and call for new elections. In that case maybe the banks stay closed and the ECB does not start the resolution process until the Greek people decide what they want. But in any event, it’s over for Tsipras in that case as well.

The German fiscal disciplinarians have won the battle. Tsipras dies under that bridge. The end!
A weaponized financial system indeed! These kinds of bare knuckled negotiating tactics are likely to push Tsipras into blinking, signing a deal and falling on his political sword. As the time of this writing, Bloomberg has reported that Tsipras has presented Merkel, Hollande and Juncker a last-minute proposal that crosses his own red lines on pension reform. We'll have to see how much ground Greece has given and if the provisions are satisfactory for the Eurogroup.

Supposing that Tsipras doesn't sign the deal and decides to default, we can consider the Cypriot experience of what might happen next. The chart below shows the price action of the Euro STOXX 50, the SPX (top panels) and the Athens General Index (bottom panel) during the Cypriot bail-in. The Greek banking system was highly exposed to Cyprus so it had a higher Cypriot beta, while US stocks were the least exposed so they barely reacted at all. European stocks were somewhere in between. Stock prices fell on the day that capital controls were announced (remember that it was surprise). They staged a two-day rally (weak for Greece, stronger for Europe), declined for a week afterwards to a bottom and then rose afterwards. The lack of reaction from the SPX was likely indicative of how far removed the Cypriot situation was from the US economy and financial system.

The bottom line: Expect a short-term rally, followed by a possible decline into an ultimate bottom. In any case, the downside is limited.

Synthesis: Long Europe, short US
Based on this analysis, I continue to believe that the intermediate term direction for US stock prices is down. US equities moved into a mild overbought condition on Thursday and, if recent history of the narrowly range-bound market were to repeat itself, we are likely to see further declines early in the week. On the other hand, a bearish beta exposes a simple short position to the risk of a Greek driven rally. Quantitative models suggests that the beta of the SPX to Greek news is relatively low. This chart of the relative performance of Greek stocks compared to eurozone stocks indicate that the rolling 20-day correlation of Greek relative performance to the SPX is only 0.30.

This chart shows that DAX volatility has spiked while VIX has remained flat (via Jeroen Blokland), which is another disconnect.

However, these results appear highly counter-intuitive. Even with the best quantitative tools, I cannot predict how the US markets are likely to react to a Greek rally.

As a solution, my inner trader has decided to do something completely different. He has entered into a pair trade, where he is long eurozone and short US stocks to express his convictions and control risk (see my tweet last Friday) .The chart below shows the long FEZ-short SPY pair. European stocks in USD have been in a trading range against US stocks for most of 2015 and the pair is now at the bottom of the range. The RSI(5) indicator (top panel) shows that it has flashed a buy signal by bouncing off an oversold condition. Should this pair move back to the top of the range, the upside potential would be about 4.5%. If the Greek market beta of SPX is lower than eurozone stocks, which is a reasonable assumption, the upside potential could be a lot higher.

On the other hand, my inner investor remains cautious as he remains focused on the intermediate term downside risks in US equities.

Disclosure: Long SPXU, EURL