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

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