Last week was a scorching "risk-on" week for the markets, as a putative "solution" to Europe's debt problems and a positive print for third-quarter GDP convinced investors that all pressing economic concerns have vanished. We observed very little expansion of trading volume, which is characteristic of markets where short sellers are forced to cover while existing holders raise their offers and reduce their size. For our part, Thursday was difficult, as our largely defensive holdings were clearly out-of-favor, bank stocks (which we continue to avoid) shot higher on short covering, and option volatility declined as investors abandoned the desire to defend against losses.
I suppose it's needless to say that we shared neither the market's enthusiasm nor its confidence in the sudden view that everything has been fixed (more on that below). At the same time, as I noted last week, speculation can take on a life of its own when there is a pause in fresh concerns, so we're not inclined to "fight" the recent advance by raising our line of defense (which would expend option premium on higher-strike put options). The benefit of holding the existing line is that we won't get another crush in near-the-money option premium if the market advances further (which has contributed to a few percent of discomfort in recent weeks). The downside is that a sharp reversal lower won't benefit us much until the market loss exceeds about 3-5%. So we remain defensive here, but as a concession to the speculative inclinations of investors, we are not putting up a contrarian fight.
Beyond that, however, we don't have the evidence here to establish a material positive exposure or "go long" - at least not at present. Current market conditions cluster among a set of historical observations that might best be characterized as a "whipsaw trap." Though last week's rally triggered several widely-followed trend-following signals (for example, a break through the 200-day moving average on the S&P 500), the broader ensemble of data suggests a high likelihood of a failed rally. In this particular bucket of historical observations, less than 30% of them enjoyed an upside follow-through over the next 6 weeks. Some recent examples from this bucket include the weeks ended 11/3/00, 12/7/01 and 2/1/08. These were points that followed snap-back rallies that were actually good selling opportunities in what turned out to be violent bear market declines.
That said, about 30% of the observations in the current bucket did enjoy a positive follow-through. So while the expected return/risk profile of the market remains negative here, we have to be somewhat more tentative about taking a "hard" defensive position. As always, we'll respond to new evidence as it arrives.
On the questionable benefits of a leveraged EFSF
With respect to Europe's perceived "solution" to its debt crisis, the 50% write-down of Greek debt is appropriate (better than 21%, but probably still light), but it's not clear that this includes a writedown of Greek obligations to "official" holders such as other European governments and agencies. If not, it's unclear whether the writedown is really deep enough to allow Greece to avoid further debt problems several years out.
Likewise, I suspect that investors are celebrating various "headline" figures (such as "1 trillion euros") without much understanding of what they are cheering about. The European Financial Stability Facility (EFSF) is a Luxembourg corporation to which European states have committed 440 billion euros of backing, beyond which the EFSF must issue its own bonds to investors in order to make loans (not grants) to recipient countries or banks. There are two basic options that the EFSF contemplates for "leveraging" its 440 billion euros (which will actually probably be closer to 250 billion for all of Europe after amounts needed for Greece and bank recapitalizations). One is to issue "credit enhancements" or "partial protection certificates" that would be sold along with the new debt of European governments, where the certificates would provide first-loss protection of say, 20% of face value. Alternatively, the EFSF could construct a "special purpose vehicle" or SPV in each given country - basically an investment company formed to buy European debt - where the EFSF would "provide the equity tranche of the vehicle and hence absorb the first proportion of losses incurred by the vehicle."
So to start with, the EFSF is not actually an operating "bailout fund" at present - it's a shell corporation with a business plan and a certain amount of promised capital - not yet in hand - from European governments, in search of additional funding from private investors. Its intended business is to a) partially insure European debt, using capital from European governments, which these governments will obtain by issuing debt to investors, or b) to purchase European debt outright, by issuing EFSF debt to investors, leveraging capital obtained from European governments, which these governments will obtain by issuing debt to investors.
In effect, European leaders have announced "We have agreed to solve our debt problem, leveraging money we do not have, to create a fund, which will then borrow several times that amount, in order to buy enormous amounts of new debt that we will need to issue."
As Jens Weidmann, the President of the German Bundesbank objected about this plan last week, "It is tied to higher risks of losses and to increased sharing of risks. The way they are constructed, the leveraging instruments are not too different from those which were partly responsible for creating the crisis, because they concealed risks."
Full article: http://www.hussman.net/wmc/wmc111031.htm
I suppose it's needless to say that we shared neither the market's enthusiasm nor its confidence in the sudden view that everything has been fixed (more on that below). At the same time, as I noted last week, speculation can take on a life of its own when there is a pause in fresh concerns, so we're not inclined to "fight" the recent advance by raising our line of defense (which would expend option premium on higher-strike put options). The benefit of holding the existing line is that we won't get another crush in near-the-money option premium if the market advances further (which has contributed to a few percent of discomfort in recent weeks). The downside is that a sharp reversal lower won't benefit us much until the market loss exceeds about 3-5%. So we remain defensive here, but as a concession to the speculative inclinations of investors, we are not putting up a contrarian fight.
Beyond that, however, we don't have the evidence here to establish a material positive exposure or "go long" - at least not at present. Current market conditions cluster among a set of historical observations that might best be characterized as a "whipsaw trap." Though last week's rally triggered several widely-followed trend-following signals (for example, a break through the 200-day moving average on the S&P 500), the broader ensemble of data suggests a high likelihood of a failed rally. In this particular bucket of historical observations, less than 30% of them enjoyed an upside follow-through over the next 6 weeks. Some recent examples from this bucket include the weeks ended 11/3/00, 12/7/01 and 2/1/08. These were points that followed snap-back rallies that were actually good selling opportunities in what turned out to be violent bear market declines.
That said, about 30% of the observations in the current bucket did enjoy a positive follow-through. So while the expected return/risk profile of the market remains negative here, we have to be somewhat more tentative about taking a "hard" defensive position. As always, we'll respond to new evidence as it arrives.
On the questionable benefits of a leveraged EFSF
With respect to Europe's perceived "solution" to its debt crisis, the 50% write-down of Greek debt is appropriate (better than 21%, but probably still light), but it's not clear that this includes a writedown of Greek obligations to "official" holders such as other European governments and agencies. If not, it's unclear whether the writedown is really deep enough to allow Greece to avoid further debt problems several years out.
Likewise, I suspect that investors are celebrating various "headline" figures (such as "1 trillion euros") without much understanding of what they are cheering about. The European Financial Stability Facility (EFSF) is a Luxembourg corporation to which European states have committed 440 billion euros of backing, beyond which the EFSF must issue its own bonds to investors in order to make loans (not grants) to recipient countries or banks. There are two basic options that the EFSF contemplates for "leveraging" its 440 billion euros (which will actually probably be closer to 250 billion for all of Europe after amounts needed for Greece and bank recapitalizations). One is to issue "credit enhancements" or "partial protection certificates" that would be sold along with the new debt of European governments, where the certificates would provide first-loss protection of say, 20% of face value. Alternatively, the EFSF could construct a "special purpose vehicle" or SPV in each given country - basically an investment company formed to buy European debt - where the EFSF would "provide the equity tranche of the vehicle and hence absorb the first proportion of losses incurred by the vehicle."
So to start with, the EFSF is not actually an operating "bailout fund" at present - it's a shell corporation with a business plan and a certain amount of promised capital - not yet in hand - from European governments, in search of additional funding from private investors. Its intended business is to a) partially insure European debt, using capital from European governments, which these governments will obtain by issuing debt to investors, or b) to purchase European debt outright, by issuing EFSF debt to investors, leveraging capital obtained from European governments, which these governments will obtain by issuing debt to investors.
In effect, European leaders have announced "We have agreed to solve our debt problem, leveraging money we do not have, to create a fund, which will then borrow several times that amount, in order to buy enormous amounts of new debt that we will need to issue."
As Jens Weidmann, the President of the German Bundesbank objected about this plan last week, "It is tied to higher risks of losses and to increased sharing of risks. The way they are constructed, the leveraging instruments are not too different from those which were partly responsible for creating the crisis, because they concealed risks."
Full article: http://www.hussman.net/wmc/wmc111031.htm
