Bubble Bubble Toil and Trouble

We had a perfect recipe for the “abrupt” correction that global asset markets have experienced. A quick look at the factors shows observant investors that caution was necessary leading up to the most recent FED meeting. 1)    Leverage as measured by NYSE margin debt released in May showed levels greater than that of 2007 and close to all time highs. This excessive risk appetite can be attributed to an extremely low interest rate environment and low volatility in the broader market. Said simply – leverage is cheap, and the stock market doesn’t decline for long, because of the FED put in the Bond markets… Chart courtesy of DShort @ Advisor Perspectives.

2)    Economic indicators have improved in an assymetric fashion in that corporate earnings and growth have been solid, jobless numbers have been improving along with retail sales and consumer confidence, but labor participation rate has a fairly steep negative trend, housing starts were trending positive but experienced a dramatic decline and real gdp has been volatile. Charts via the New York Times and FRED where applicable, sources are cited in chart.

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3)    About that FED put… It has been rumored for some time now that Bernanke and the FED had to begin its exit plan. Market participants have known sooner or later that day would come but volatility had been so low, and debts so large especially with the FED being the largest US debt purchaser that it always seem to be coming next year, or the year after. Well Bernanke slapped the market to attention when he said nothing to contraindicate the rumors that tapering could begin as soon as the 4^th qtr of this year.

 

Whoops! So the mad rush begins as investors have no choice to begin deleveraging immediately. And by investors I don’t mean the average 401k or boutique investment shop. I’m talking about the big boys who literally move markets. These players are leveraged to the hilt and need to begin unwinding interlinked trades across various asset classes. Think carry trades used to speculate in emerging market assets, currencies, and leveraged bets using derivatives.

Bond markets have also been flashing warning signs. The chart below represents a high correlation period between the HYG and LQD etf's, and the S&P 500, which act as good proxies for risk appetite especially. Beginning in early May there is a clear divergence between the stock market and bonds.

Couple these factors together and it appears that we have entered a correction phase in asset markets, as some of the “froth” gets wiped away and the players reposition themselves. In future posts I will examine the linkages between shadow banking system, the players involved and the necessity of deleveraging. I will also look for the signal that gave investors the go ahead to get risky in the last round of forced deleveraging.

WHO RUNS THE MARKET?

A simple question, often overlooked to the investors' detriment.... In my ongoing pursuit to gain an edge in the market I’ve often thought it critical to analyze who the key players are. But even more broadly and perhaps of greater importance, I’ve often considered who or what forces have the power to “move the markets”. As a casual observer, or "unsophisticated" investor the most common market news you may encounter is pundits discussing stocks and the stock market, earnings reports, the FED and various economic indicators. The layman could hardly be blamed for thinking the stock market is the most influential economic market in the U.S. if not the world. Consider the enormous amount of attention that is given daily to the U.S. stock market. How critical it was and continues to be for the FED and government decision makers to consider “the market” in their decision making.

Here exists the ironic, easily obscured truth. When the FED and key shot callers reference “the market” most investors immediately think  "the stock market". I used to be guilty of this myself, but it is not only a serious error but also a limiting thought process.  Consider why? The equity market is in actuality the smallest of the actively traded markets. Let’s examine the data and the importance of this analysis will become  clearer.

According to 2012 World Bank data, global equities had a market value of approximately $53 trillion current USD. The Bureau for International Settlements (BIS) quarterly data approximates Total global debt securities at $86.6 trillion. That’s over 1 and a half times the market value of all equities. The BIS Triennial 2010 survey, reported the foreign exchange (Forex) market had an OTC notional value of $63 trillion in total contracts. Total OTC derivatives accounted for $632 trillion in outstanding contract values. That’s 12x the size of the global equity market.

 Average daily trading volume (ADTV) also helps tell the story.

Forex trading has the largest ADTV followed by U.S. debt securities, then global interest rate derivatives. Examining the ratios; Forex trading volume is almost 19x larger than U.S. equity market volume; U.S. debt securities 4.2x larger and interest rate derivatives are 3.4x larger.

Bottom-line, U.S. equities account for the smallest piece of the asset market pie, both in market value and average daily trading activity.

The implications cannot be overstated. The “market” is a huge web of interconnected asset classes arranged in a hierarchical order with U.S. equities located at the bottom. Equities serve as both an expression of market expectations on real economic output; and of the volatility occurring across all interest rate based securities.

Examining these larger securities’ markets can provide indicators to actionable trading ideas. The leverage and capital at risk is so large in these markets, significant, far reaching dislocations can occur as a result of something conceptually “simple”, like an interest rate hike or a currency peg. These events blow holes in the efficient market hypothesis and allow for astute traders to place favorable bets with asymmetrical risk-reward properties.

This subject will be an ongoing topic of discussion and analysis, as these events typically increase emotional intensity and therefore volatility. The extremes in emotions present the greatest opportunities for the prepared and courageous investor.