MARKET RECAP: Sultans of Swing

Volatility ruled the week (ironically as the VIX closed near recent lows) as the stock and bond market wrestled each other. Bonds made a new low Wed morning before bouncing to stabilize near 5.25% on the 10YR and put the bottom in for equities which vaulted back towards a few points of the previous high in an option expiration short squeeze. The dollar/yen exploded to a new high with shorts caught and a positive sloping yield curve driving the buying. The euro/yen saw a slightly larger move, rallying 2.3%, though closed just shy of its previous rally. This coinciding with a non-action out of the BOJ tells us the carry trade was back on en masse providing a positive catalyst for equities.

INTERNATIONAL INTEREST: Shake Your Money Maker

The carry trade was back with a vengeance this week as market participants received greet light from the BOJ and were able to lock in attractive spreads in the US and Europe with their central banks remaining hawkish. This sent the dollar and euro screaming +2% higher v the yen, with the JPY trading at a new high. There is not much else to say other than this is a reflection of the risk taking in the market and the willingness to lever positions. The higher bond yields were definitely supportive of the currencies earlier in the week despite weakness in stocks and once it appeared 5.25% would hold, the carry trade was put back in motion.

With the dollar and euro both exploding in what could be a final impulsive move out of a correction has us remaining in defensive mode. Hey these babies can travel much further than you realize, but that doesn’t mean you should chase it either. We continue to find value in simply monitoring these markets for confirmation of equity direction and risk appetite. With Japan’s GDP growth surpassing the US and Euro zone we would be very cautious about a short yen position as this carry trade may be in the late innings and the reversal will be violent as players are trying to exit the door at the same time.

Bottom Line: The carry trade was either in massive short squeeze or back on with a vengeance this week as the markets stabilized. This pattern looks to be in the late and final innings of an advance and looks to be very vulnerable to a reversal. We continue to monitor these markets for signs of de-leveraging.

COST OF CAPITAL: Tied to the Whippin’ Post

Volatility continued in the bond market with successive new lows before rebounding on Wed as value buyers seemed to step in to defend the 5.25% area on the 10YR note. The news out of Bear Sterns that they were liquidating a leveraged mortgage “hedge” fund may have been one of the main culprits behind the violent selling. We recalled the Vega bond fund that blew up last year as their short bets were being blown out last autumn during the flight to quality bid surrounding Amaranth. And they say the bond market is boring. Inflation and other economic data looked benign and we may have seen somewhat of a relief rally as traders who were apprehensive about catching a “falling knife” were more comfortable nibbling at the highest yields in a year. Bottoming is a process and especially in the bond market as yield levels are live benchmarks. First it was 5.25% for 10YR, then 5.20% and 5.15%. The ability of the market to hold these levels will make it easier for buyers to step back in and put money to work and there did appear to be some dip buyers on Thu and Fri as the market made a series of higher highs and higher lows . The yield curve will now be important to see if the market is stabilizing as the back up in real yields has accounted for most of the move. At a 2.75% real interest rate implied by the TIPS market traders will be discounting now whether growth can exceed that level or there is about to be a pick up in inflation. This is the bet for bulls and bears and the discount should show up in the yield curve. If the curve steepens further we could be looking at an inflation scare which can feed on itself. If the curve flattens I think the market will be satisfied that inflation is tame and the economic growth trajectory will be confined to the 2.5%-3.00% range.

Next week the economic calendar is light and the market will be battling resistance and technical damage. Barring any news, it will likely be a back and fill grind. There is risk of a further meltdown but it would be so damaging to assets and the economy with think the odds are remote. If the 10YR loses 5.25% it would bring in possible further downside as convexity sellers who were responsible for the massive volatility would be forced to sell more duration.

Bottom Line: The bond market seemed to be in a mini panic reminiscent of the March Stock market mini panic. We believe the market has stabilized for the time being but would not be surprised to see another leg down to flush out the 5.25% 10YR buyers like they did at 5.00%. A break of that level could bring in more mortgage selling and thus we remain defensive until we can see some lower yield levels bring in more buyers.

BETA MAXIMUS: I’m a Ram, My Man

Equities having been handcuffed by the bond market (recall we have been saying they were not in charge of their own destiny) was on the defensive this week until bonds were able to stabilize which was the catalyst for a big option expiration short squeeze that took the S&P back within a few points of the previous June highs. We had believed the initial move off the top had the potential to be a head fake before vaulting to a new all time high and that appears to be what’s in the cards. Where it stops, nobody knows, but we think this impulsive rally could be finishing off a pattern from last summer’s lows and would reiterate our strategy from last week to use strength and rallies to peel out of longs and raise cash.

While it could in theory continue higher, we are suspicious and watching both bonds and the yen for clues. Any reversal from a new high that coincides with reversals in the dollar and euro v the yen should be taken very seriously. Also a botched private equity deal, another hedge fund blow up or if bonds lose 5.25% (which could be the catalyst for the two prior) those too could be a catalyst for a reversal. This type of volatility should be a warning sign and we are heeding it.

Bottom Line: Stocks survived the bond market perfect storm and look to be headed towards a new high. We are skeptical of the advance and are becoming even more defensive on the rally as it could reverse quickly. This week expect some consolidation prior to another advance.

DUKE & DUKE: All Along the Watchtower

Oil had been confined to a range between $60 and $67 for the past few months but broke above that range on Friday as traders seem to be discounting a bit more security premium. To me this market has been asleep and off the radar for many market participants as spike in gasoline and the crack spread was garnering more attention. We must keep an eye on this one as a big move higher in crude, which the chart could be signaling if breakout is real, could be a drag on consumer spending which has been holding on by the ability to access credit. Crude spiking could also have implications for the bond market. It’s almost as if the market is telling us there is some news coming.

Bottom Line: Crude is a sleeping giant and could spell trouble for the consumer if we get a sustainable breakout from this multi-month consolidation with implications on all asset returns.

THE EX ANTE FACTOR: Presence of the Lord

We learned this week that volatility and momentum can trump sensible trading when the markets are leveraged and performance driven. A mini panic in stocks in March and a mini panic in bonds in June should be viewed as a precursor to what can happen if the leveraged try to unwind at the same time. We don’t think it is a coincidence that two of the largest (and in theory most liquid) markets in the world have experienced brief liquidity shocks during a time that is commonly referred to as “goldilocks” and view the volatility as troubling and confirms our belief to maintain a defensive stance. Last week we suggested the stock market could be in store for a parabolic run back to new highs and even warned that it could be brief. We did not, however believe it would only take 3 days. The wave structure of this impulsive rally has the potential to end in a blow off top that could pull in weak hands right near the end of the advance. This type of advance can reverse quickly and with the summer illiquid trading, actual volatility is expected to remain elevated.. With the dollar and euro appearing to be on their own final impulsive advance from the previous lows and with the bond market on edge, we see more things that can go wrong rather than the slight margin of error that is discounted. This week we will look to see some calming of the markets in a consolidation period that may only last a couple of days as the markets waste time before the following week’s FOMC meeting. Expect the market’s to make a higher high but don’t be seduced by the cheerleading that is bound to cover the media.

We reiterate our strategy posted last week to use this rally to sell longs and raise cash. The 5.00% 2YR and 5.15% 5YR offer very compelling alternatives and we will be using this opportunity to lock in some attractive risk-free yields at the short end of the curve. While higher yields could be in store, this would likely put pressure on all other asset classes with cash and the short end of the yield curve outperforming. Investors with a somewhat more aggressive longer term horizon are encouraged to seek high quality dividend paying equities with lower beta.

What is the Discount?
This week’s recovery in stocks which corresponded with stabilizing bond yields took risk premiums to the lowest levels of the year. Looking at the Implied Equity Risk Premium at -.01% v comparable corporate bonds is indicative of the private equity return on capital/cost of capital arbitrage being removed. Private equity (who are also battling tax implications in Congress) will be less active and aggressive if their cost of capital remains equal to the return on capital.
The implied risk premium over 10YR treasuries has declined to the lowest level of the year and a full 50bps below the average indicating stocks are more expensive v risk free bonds (no surprise there). In our opinion even the most aggressive investors should only have a 50/50 equity/corporate bond weighting with a rising weighting of cash and short term risk-free governments which should provide solace in what looks to be a high volatility environment.

Had you invested 10 years ago your annualized returns after re-investing either in cash or the index is roughly still equal to what is being discounted by current markets. You can see that back then investors were offered much more attractive 10YR treasury yields. I’m sure many pundits and strategists cited the Fed model back then as well, though at 68bps, you were hardly compensated for the risk of holding equities through those tumultuous years. Either the bond yields must continue to rise or stock yields must rise (P/E fall) in order to provide investors with comparable returns. That is why we prefer cash and short term treasuries at +5%.

Bottom Line: Over the last 12 months we have seen massive hedge fund blow ups in Energy (Amaranth), Treasuries (Vega) and Mortgages (Bear Stearns) due to high degrees of leverage and tight liquidity. These events should be a warning for investors as currencies and equities could be next. The resurgence of the carry trade and weakening yen despite accelerating Japanese economic growth is counter intuitive and potentially a sign of an imminent reversal. Private equity has been the poster child for the leveraged credit cycle and the arbitrage they have been exploiting since last year seems to be tightening. Rising risk premiums in bonds imply rising risk premiums in stocks which would push P/Es lower. Due to the amount of leverage we think the adjustment could be painful if everyone attempts to exit at the same time.