Published February 18th, 2013
With global credit and equity markets raging, we are revisiting our risk indicators – the ones we’ve been monitoring since 2006. Some are long term, some short term. Some are investor-sentiment driven, others meticulously follow systemic risk. By themselves they mean very little, but collectively they provide a 20,000 foot view of global market risks.
For the long haul, stocks are very cheap. A multiple with a 14-handle on this year’s earnings, after a 10-year flat run for stocks and a performance explosion for bonds, there’s no question where true value lies.
At the end of the day, performance in today’s markets will be governed by the entry point. Keep half your money in stocks for the long haul, use the other half to trade the politically driven fear and complacency. This is where the real returns will be found.
Since Lehman Brothers went bust, if you added to your stock market holdings during moments of real, politically driven fear and sold on complacent days, you would have outperformed the market by a long shot. But how is this achieved in practice? It is done by analyzing our basket of risk indicators, because they will always tell you how much risk is lurking in the markets.
So far in 2013, the S&P 500 is up 5.48% in only 17 trading days! Short-term, the next 45-days are a screaming sell.
Let’s start with the most important part of our risk indicators; systemic risk. These are my favorite because they tell you just how big the drops may be, or how many floors the elevator may skip on the way down – how severe a near-term sell off will be.
The Holy Grail of measuring systemic risk is by monitoring how much banks trust each other around the world. There were so many warning signs before Lehman; before the flash crash in 2010; before the 20% drop in the summer of 2011, and before the 10% May-June 2012 market dive in the S&P 500.
The closer you are to a “Lehman Moment,” the more systemic risk is in the markets, which could take ten years to normalize. The VIX has spent more days above 30 in the last 5 years than it did in the previous 17-years combined. The Lehman effect will be with us for years to come.
If we look at the great financial panics over the last hundred years, (1907 and 1929) there is a healing period which follows with some of the most difficult to navigate waters. We’re not even half way home coming out of the 2008 great financial crisis. We must be ready for what’s ahead. Life changing turns are still coming our way.
The further we sail from Lehman, the longer the runs of complacency will be. In “Colossal Failure,” we talk about the absurd period between 2004-7 where the market spent some 65 weeks without an 8% pullback.
If you look at the VIX since 2008, you can see a clear psychological healing process going on. Investors still carry with them fresh scars from 2008, which limits the run time of those complacency sprints. It’s been 25 weeks, and the market has gone without a 10% correction. The sell off we experienced from the end of September though the November 16th bottom was only 6%. It was the smallest systemic move lower in the market since Lehman, a sign that markets are trying to normalize.
The VIX slayed by the Fed & ECB policy blows
Before that, the previous run without a 10% correction was Jan-May 2012… 5 months. The last two January’s are two of the best in the last 50 years; rare times indeed.
When looking at systemic risk, the key is to measure interbank lending trust. We all know banks trust each other today, but how much? Is there more trust of banks in Asia and Australia, than in Italy and Spain? You bet.
It was truly amazing in the early spring of 2011. The market lost nearly 20% between July 25th and Sept 1st, but big banks had been pulling away from each other from early May. This gave us a lot of conviction on the short side, and we subsequently made some great calls for our clients. What were we looking at?
The epicenter of systemic risk in 2011 was all over Europe, as banks were exposed to the price collapse of Greek government bonds, but today the risks are concentrated in only one country – Spain.
Our sentiment is short-term bearish only. We do feel that for the long haul, stocks are cheap. This rally is a little long-in-the-tooth, and we should all raise cash to prepare for a mild storm.
1. Realized Vol on Euribor, Libor
Say what you like about Libor and Euribor being fixed in 2005-8, but they have been a solid systemic risk indicator since. Better yet, realized volatility (how much they move day to day) on Euribor and Libor has been amazingly predictive, it was spiking just before the flash crash in 2010, in May 2011 and April 2012. Today it’s as calm as it’s been in years. On a scale of 1-10, ten being red alert, the risk indicator here is a 3. This doesn’t mean we’re not going to have a 3-5% pullback soon, which we may. It just means a true systemic sell off 10% or more is not in the cards in the next 1-3 months. We take a look at this every day. When they they start singing, I’ll be right there with ‘em.
2. Two Year Swap Spread
If banks in Europe start pulling away from each other in overnight repurchase agreements, and short term loans, this is sure to spike. Once again, looking at realized volatility on the 2 year swap spread gives you a two to three week lead time on serious market sell offs. In 2010, 2011 and 2012 before each serious market sell off, realized vol on 2 year swaps was spiking. There was a clear breakout to the upside. Today? It’s in a multi month base, coming off a serious downtrend. On a scale of 1-10, it’s a 3 in terms of any warning whatsoever.
3. Repo rates, EONIA
Banks have lots of assets on their balance sheets. They use these holdings to raise cash on a daily basis. If you know who to call, tracking the cost of this funding is a valuable risk measurement in the market. In the 9 month period before Lehman’s failure, the cost of short term loans like repos were sharply spiking. The same could be said about many French banks in the spring of 2011 as the world was concerned about their exposure to Greece. Today, banks in Italy and Spain are experiencing rising costs in this area. Our systemic risk score here is a 5 and rising.
4. TED Spread
Everyone knows what the TED spread is, but it’s still a classic systemic risk indicator. Our systemic risk score here is a 2.
5. A Breakout Short Interest on the Largest Banks
In 2007, we were watching this like a hawk in the USA. In 2012, once again it’s Spain and Italy. Let’s face it, the smartest investors play on the short side. The Chanos’s and Einhorns of the world need to borrow large amounts of stock to take a position. Therefore a breakout in short interest in the major bank equities is a bearish sign. In the summer of 2008, early spring 2011 & 2012 there was a classic breakout in this indicator. Today, our systemic risk score here is a 5 and rising.
Here’s a chart of Santander:-
6. Credit Spread between Big Banks and Industrials
Last April – May 2012, as well as May 2011, the credit spread between the iTRAXX Main (corporate bonds in Europe) and iTraxx Sub Fin (subordinated corporate bonds in the financial sector in Europe) was blowing out. Financials had a credit spread 120bps wide of industrials… today they trade 5-15bps wide. Since Lehman failed, when 5 year CDS on the big banks is in an uptrend, then the financials are weekly or monthly underperformers in credit (in comparison to other industries). Our systemic risk score here is a 3 and rising. The lessons of 2010, ’11 and ’12 tell us that when these spreads start to really widen, lighten up on stocks in general.
7. Tertiary Capital Structure Activity
By and large CFO’s are not stupid. They access the capital markets to borrow money when the credit markets are healthy. But exactly how much access to capital do they have? This can be measured by the type of debt issuance in the league tables the banks proudly present to the street. Banks are always thrilled with lively capital market activity, and this information is easy to find. In 2007, we saw an explosion of subprime MBS issuance, but another telling area to watch is the PIK Toggle and Hybrid Bond issuance levels. How much power a CFO has over investors can be measured here. Something truly bizarre is going on in Europe, in particular France. I hate both France’s sovereign credit as well as most corporate credits across the country. Credit spreads are just way too tight for a country heading into a clear and obvious recession. There was a new all time record Hybrid bond sale yesterday. A colossal $5.3 billion Hybrid bond was sold to investors by French utility EDF. The previous record was $GE ‘s $3.2 bln in 2007, yes GE in 07! You can’t make this stuff up. I can’t emphasize enough what a classic risk warning sign this is. The pace of Hybid bond sales over the last 52 weeks in DOUBLE the previous 52 week mark. Our systemic risk score here is a 7 and rising.
8. Spain and Italy Credit Spread Over Germany & Curve Steepness
Over the last 4 years the steepness of the Spanish sovereign bond curve has been a fantastic risk indicator. As the curve has flattened in 2011 and 2012 it made sense to lighten exposure to equities. In a flat curve, short term bonds yield similar amounts to long term bonds. In April May 2012, the Spanish 2s – 10s spread got inside of 50bps, the 10 year bond yield was near 7.4% and the 2 year was 7%. In the months before the Lehman bankruptcy, as in all Chapter 11 filings, the curve was flattening month by month. Spain’s bond yield spread over German Bunds is something we watch every day. Mario Draghi’s OMT program has changed this game somewhat, but the 5-year bond is something to watch closely as it is outside of the ECB’s bond buying mandate. Our systemic risk score here is a 4 and rising.
9. Correlation
The 50-Day correlation of S&P 500 stocks to gains or losses in the full index increased to a near record 0.86 in October 2012. It was 0.93 in the days around Lehman’s failure, the granddaddy of all correlation moments in the markets. This is a measure of how stocks in the S&P are acting like each other. During normal, healthy markets correlation is low. IBM shouldn’t move with MGM Casino’s in a normal market, but should move independently depending on true company specific news flow. A level of 1 would mean all 500 stocks moved together. August-September 2008, May-Sept 2011, April-May 2012, rising correlation existed across all asset classes. A breakout in the ICJ, the CBOE S&P 500 Implied Correlation Index, which occurred on September 2nd 2008, July 11th 2011, and April 17th 2012, is very bearish for equities and commodity prices. Our systemic risk score here is a 4 and rising.
10. Two Month VIX Future vs. 8 Month VIX Future
Money flow from the 8 Month VIX Future into the 2 Month VIX Future has been a solid short term “risk off” indicator. As money moves from the 2 Month VIX Future to the 8 Month, this has always been solid short term “risk on” indicator. Why? Just about every hedge fund on the street has a risk manager in a trading capacity. At Lehman, we were long billions of dollars of high yield bonds and every day we could hedge our exposure. If the market crashed, we’d make money short equities, and lose money on our bonds. One of the watering holes where risk mangers reside is trading the VIX – volatility. By tracking the 2s vs 8 month money flow you can see elephant footprints, see where the smart players are making their bets. Our systemic risk score here is an 8 and rising. The smartest money is stepping into short-term protection.
11. Investor Sentiment
If you look at Hulbert newsletter writers, this tracks bullishness and bearishness among market pundits. Right now they recommend an 81% net long exposure, the highest since July 2000, the next highest December 2004, and May 2010. No matter how many people on CNBC tell you “everyone is bearish,” track the numbers. Another good one here, only 24.5% of advisors in Investors Intelligence survey looking for a “correction.” That is the fewest since 14-Sep when their number fell to 21.3%. That was the last market high when optimism was abundant. The September 14th reading was a classic short term top in the market, preceded a cool 7% drop. Our systemic risk score here is a 9 and rising.
12. Percentage of Stocks Above their 50 Day Moving Average*
This week a remarkable 79.9% of the stocks in the S&P 500 hit the overbought level across our model. The chart below is a classic breadth measure. The market is extended here to say the least. As shown, 90% of the stocks in the S&P 500 are currently trading above their 50-day moving averages. This is the highest reading we’ve seen over the last year, and it’s only the sixth time we’ve crossed the 90% barrier since the bull market began in 2009. Bespoke research confirms these findings. Our systemic risk score here is a 9 and rising.
13. CBOE Put Call Ratio
When nobody’s buying puts, lookout on the long side, and when everyone is buying puts GET LONG STOCKS. The ratio hit a recent low this week at 0.73. When stocks made that recent bottom on November 16th, the ratio hit 0.86, a lot of investors were looking for downside protection. THE CROWD IS ALWAYS WRONG. The only way to beat them is to go the other way. Our systemic risk score here is 8 and rising.
14. NYSE New Highs vs. New Lows
This indicator is much better at predicting market bottoms vs. market tops. Peaks in NYSE New 52 week lows are a classic buy signal. The near 2000 all time record after Lehman, hopefully will never be broken. More telling is the MACD on New Highs / New Lows, when the 50, 100, and 200 day turn negative, it’s a solid sell signal. Our systemic risk score here is a 8 and rising.
15. High Yield vs. Equities
By definition, the high yield market is not as liquid as the stock market. In the months before the 2011 sell off, as well as during the summer of 2008, high yield bonds were dramatically underperforming equities. Today both high yield and stocks are on fire to the upside. Typically, before substantial pull backs in equities, high yield will start to underperform. Our systemic risk score here is a 6 and rising.
16. High Yield Fund Inflows
If you look back over the last 10 years, most market tops take place around the same time of record inflows into high yield bonds, coming from the retail investor base. J.P. Morgan’s weekly analysis of European high-yield funds shows a €413 million inflow for the week ending Jan. 16, which is the largest weekly inflow on J.P. Morgan’s records (which date back to 2005). Of this, €56 million is attributable to ETFs. The reading for the week ending Jan. 9 is a €180 million inflow. The provisional reading for December is an inflow of €1.67 billion, and the 2012 total currently stands at a €7.97 billion inflow. Our systemic risk score here is an 8 and rising.
17. Corporate Default Rate
Moody’s global speculative-grade default rate ended 2007 at 0.91% – approximately 48% lower than 2006’s year-end level of 1.74%. This was a classic warning sign for stocks. The speculative-grade default rate finished the fateful year at its lowest level since 1981 when it came in at 0.70%. The default rate for all Moody’s-rated corporate issuers fell to 0.31% in 2007 from 0.61% in 2006, also over a two-decade low going back to 1981.
US corporate family defaults remained steady in the final quarter of 2012, Moody’s Investors Service says in the latest edition of its quarterly “US Corporate Default Monitor.” Just seven non-financial corporate families defaulted during the quarter, for a total of nearly $9 billion, compared with 16 defaults representing approximately $10 billion in the same period a year earlier. “Continuing low interest rates and accessible credit markets have kept the default count light among speculative-grade corporates,” says Moody’, “and we expect it to edge even lower this year in 2013.” Moody’s forecasts the US speculative grade default rate to end 2013 at 3.0%, below the average of 4.5% since 1993 and well below the cyclical peak above 14% in late 2009.
BOTTOM LINE: Raise cash. Your exposure to the markets now should only be your core positions. If you are feeling brave, go short. Our goal is to point your ship into fairer winds. Good luck, and stay poised. We think a storm is brewing.
Downtown Josh Brown
Elliottwave Forecast
Michael McDonough
Mark Dow
John Carney
