Shift Of Focus for Stocks

Given that we now have a resolution to the banking problem, the stock market will likely shift its focus to normal indicators such as earnings and macroeconomic releases. These are still going to be bad, but not quite as bad as they used to be. In fact, I look forward to an improvement in the economy. I'm not expecting any growth until next year but I do think that the economy will not look quite as bad as it has in recent months. This shift of focus should push stocks higher still.

Black Swan Event in the Bond Market

The Fed announcement caused a black swan event. To put today's events in perspective, the 10Y yield 20 day chart looks like this:

Since 1962 the 10Y yield moved by more than 0.47% ten times out of 11960 days. So the probability of this occurring on any given day is 0.084%.

Needless to say, inflation expectations are going to go up:

Consumer Mood Improved Last Week

From Gallup:

Gallup’s Consumer Mood Index rose sharply over the last week, to -90 for March 13-15. This is up from -120 a week ago and is the most positive the Index has been since mid-September 2008. The increase is commensurate with the four-day consecutive gains in the Dow Jones Industrial Average, beginning last Tuesday, and also with the Obama administration’s recent emphasis on more positive views of the economy.

This may translate in improved readings on retail sales and PCE as well. It is a bit difficult to find reasons to sell stocks in the short term. We should be seeing more positive news as the stimulus impacts the economy some time soon.

Credit Conditions Improving

Credit conditions have been improving and will likely continue to do so over the next few weeks. This is likely to put upward pressure on stocks.

A lot will depend, however, on how well the plan to fix the banking system is received.

Update on Eurodollars Trade

I've discussed a couple of interest rate trades here. Since the model projects zero growth in about 12 months, being long bonds with short maturities should work out well. A good way to go long short maturity bonds is to simply go long Eurodollar futures contracts. These trade actively on the CME. Since I suggested going long the Mar'10 Eurodollar contract (EDH0), it has rallied slightly. Back on March 8th it was trading at yield of 1.67%. On Friday it closed at 1.625%.

Keep in mind this trade has a horizon of six to twelve months.

There is a risk here of LIBOR to treasury spreads moving higher in the short term, but I don't think this risk is significant in the long term. The LIBOR to treasury spreads have edged higher lately as banks still seem worried about lending to each other. The difference between LIBOR and treasury rates is called the Treasury Eurodollar (TED) spread shown in the figure below.



If you want to avoid exposure to the TED spread you might want to buy the two year note (T 0 7/8 02/28/11) yielding 0.956%.

Disclosure: I could be long or short Eurodollars or treasury futures at any point in time. I do not trade the 2Y note.

Update On the Inflation Trade

Just a quick update on the inflation trade I recommended here. On March 8th, the index stood at 0.1910, as of Friday's close it was at 0.3170.



Based on the model inflation is poised to move to at least levels prior to Aug of 2008.

Disclosure: I do not own inflation indexed securities.

The Uptick Rule Makes Buying More Tricky

I have seen a lot of press lately that the uptick rule will be brought back. In short, Wikipedia defines the uptick rule as follows:

The rule limits the timing of short sales. It mandates, subject to certain exceptions, that, when sold, a listed security must either be sold short at a price above the price at which the immediately preceding sale was effected or at the last sale price if it is higher than the last different price.

The key here is that the uptick rule can limit the timing of short sales, but not short sales themselves. I have not seen any in-depth analysis of what effect the up-tick rule has on the price discovery process if any. But lets take a look what it could potentially mean.

As a market participant you have basically two choices when you place an order. You can place your order at the best offer (BO) price or higher, or you can place it at the best bid (BB) or lower. If you place it at BB or lower, you should get filled almost immediately. If you place it at BO or higher, you will have to wait until someone else places a bid your price.

Now, with the uptick rule in place, if you place your offer at BB or lower, and the last trade was at a price higher than BB, the exchange will not execute your order. I'm not sure what they would do with it, I imagine that they will either reject it or defer it until the price ticks up. It is quite possible, that because the exchange will wait for an up-tick, you will be able to sell at a price that is one tick better. Does your action of selling at slightly better price have smaller negative impact on the market? No, I don't think so. It doesn't matter how you sell, as long as you can sell you will have some negative impact on the price.

The uptick rule creates a share of problems for the buyers as well. If you are interested in buying at a given price, you want to know that there are enough people interested in selling to you. However, if you happen to want to buy at a price that is not an uptick, the short sellers will not be able to sell you to. You may then have to wait for an uptick and buy at a higher (worse) price.

It is not true that the uptick rule prevents bear market or stock market crashes. The uptick rule has been in place during the recessions of '74, '81 and 2001 and the crash in '87. To suggest that without the uptick rule any of those episodes would have resulted in smaller market declines is absurd. If anything the opposite is true.

Suspension of Mark to Market Rules Nonsense

If you own an asset, you are typically interested in what it is worth. That is why you mark it to market as best as you can. Apparently, the logic behind the proposal to suspend mark to market rules for the banks is that they should not have to mark to market assets that they think will eventually go up in value.

In other words, if the assets they are sitting on decline farther in value, they don't have to tell us. The idea is that the market is wrong, and so market can simply be ignored until it corrects itself.

The obvious flaw with this argument is that we have no reason to believe that the market is wrong or that it will ever "correct" itself. Suppose that the mark to market rules are suspended for a period of two years. Further suppose that the banks mark their assets higher than the market. If in the two year period the marked does not right itself, the banks will have to realize the loss.

Chances of Positive S&P Returns Given Negative GDP

I got a bit concerned that I'm predicting that stocks will go up even though I expect the GDP to remain negative for at least 12 months. Since 1947 there were 19 quarters where the GDP was negative and S&P returns have been positive out of 38 negative quarters. So it's a bit of a toss-up.

My view that stocks should move higher in the short term, is based on the assumption that stocks have been pushed too low due to concerns over the banking system. I think that the Treasury department will find a way to resolve the banking issue, and stocks will move up. However, we should not ignore the fact that the bear market is unlikely to end until we see a substantial improvement in the GDP.

There has been an improvement in the CDS market as well but we are not out of the woods yet.

Can Stocks Go Up While Yields Go Down?

In some of my previous posts I suggested that the stock market is more likely to go up while yields in the short end of the yield curve seem a bit high. I would like to clarify the point as this is a rather dangerous prediction to make.

I went back as far as the beginning of 1997 and computed the correlation between quarterly S&P returns and changes in yield on the 2Y note. The correlation came out to be about 58%. This is quite high. (Doing this on the square root of the yield gives a slightly higher correlation.)


My view on the stock market is that people are awaiting resolution of the banking problem. If there is a positive outcome to the banking issue stocks have nowhere to go but up. Whether or not that will mark the end of the bear market I don't know.

When and if stocks do move higher yields should move higher as well, with the yield curve possibly becoming steeper. However, the 2Y yield is in many ways a projection of what the Fed will do. Since it is hard for me to imagine aggressive rate hikes in 2010 I don't think 2Y yields can move much higher and should in fact move lower.

One other thing to keep in mind is that making a projection on how correlated stocks and yields will be going forward based on past data is complicated by the fact that the Fed cannot lower rates at this point. In the past, the fed would have been cutting rates if the economy were shedding 500K+ jobs per month. Fed cuts would have pushed yields lower but now this effect is not present.

Hedge Fund Withdrawals Lower

This is good news for the markets:

From Bloomberg:

Investors pulled out a total of $11billion from hedge funds in February as stocks worldwide tumbled amid signs a global recession is deepening.

Redemptions were about a third of the value in January, after the industry lost about $400 billion from its June peak to December through market losses and withdrawals, a preliminary Eurekahedge Pte report showed.

This is a positive piece of news because it means that liquidity will decrease at a slower rate and may improve. Improved liquidity will translate into lower volatility. My guess is that lower volatility will translate into better investor confidence and drive more money to stocks.

Citi Memo is not a Game Changer

The memo from City CEO did not fundamentally change my outlook on stocks. I think we all knew that Citi would be a viable company if it weren't sitting on large amount of assets that keep loosing value. But nevertheless, the rally in credit markets was more than welcome. Stocks turned mixed yesterday afternoon. The stock market is still mixed. There is no real conviction among buyers at this point. It doesn't look like the rally will have much of a follow-through.

However, there is an easy way to change the game. All we need is a memo from Geithner to bank creditors telling them he will not ask them to take a haircut. Just one memo will do.

Oversupply of Treasuries or V-shaped Recovery?

The 2Y note traded at over 1% yield today. I think most people would agree with me that chances of the Fed raising rates within 12 months are rather low. In order for the 2Y to yield an average of 1% over two years, assuming that T-bills will average 0.25% over the first year, we will need an average yield of 1.75% between 12 and 24 months. As the FOMC usually meets ten times in a year, this assumes a rate hike every meeting starting June 2010.

It looks like either the 2Y yield is implying a V-shaped recovery. This strikes me as a rather optimistic scenario, as the probability of the recovery being U or L shaped is high. The other possibility is that the 2Y yields are elevated as there simply aren't enough buyers out there to bring it in line with more realistic rate expectations.

Credit Pushing Stocks Down

The credit markets have dragged the stock marked down with them. Indeed, the stock market is in a sense a credit market itself, so this is not a big surprise. The chart above shows CDS yields for the banks. There is an obvious spike around Oct '08, then a leveling of, and another spike up.

In contrast, if we we look at manufacturing, the two humped shape is no longer apparent. However, manufacturing spreads do look a bit worse now than back in October.


In the consumer sector, the situation is slightly better, but not exactly rosy either.


In my opinion, it looks like there are possibly two factors at play. The most important one is that the banks are in bad shape. The market expects that bond holders of bank debt are likely to loose a major chunk of the principal. The second factor is simply a general worsening of economic conditions that make it more likely for any company to default.

I take a bit of comfort from the fact that volatility is substantially lower now than it was during the Oct/Nov crash.


The volatility picture suggests to me that there are fewer people now who expect stocks to decline much farther than there were back in October. This is simply because volatility goes higher as stocks go lower.

Of course, stocks can go lower still, however, I would be surprised if the administration actually allowed banks to default on their debt. If they want to get re-elected that is.

I think that there is a better probability of stocks going higher than lower from here. Having said that, there is a distinct possibility of stocks deteriorating until the situation with banks is clarified. This could take another month or two.

When Will The Fed Raise Rates?

We have an upward sloping yield curve. If we were to ignore the risk premium we could assume that this is simply due to expectations that the Fed at some point will raise rates. The first Fed funds futures contract trades at about 22bps, whereas the Mar '10 contract is trading at about 70 bps. So this suggests that the Fed will raise the Fed funds rate by about 50bps.

I think a 50bps rate hike could only happen if the Fed comes across some serious evidence that it needs to start slowing the economy down prior to Mar '10. That seems a bit unlikely.

If we look at the Eurodollar futures contract, currently the front contract trades at 1.34 bps, the Mar '10 contract trades at 1.67. The difference between the Mar '09 and Mar '10 is less than the difference between the corresponding Fed funds futures contracts. This discrepancy could possibly be explained by the fact that Eurodollar to Fed funds spreads are expected to narrow.

I think that betting against the Fed raising rates prior to Mar '10 could be profitable. Fed funds futures don't look all that liquid, but one can consider simply going long the Mar '10 Eurodollar contract. One thing to keep in mind is that if the stock market rebounds this trade will loose money but hopefully only temporarily.

The Inflation Trade

A number of people have noticed that the inflation trade is likely to be profitable. For example, Accrueed Interest wrote about it here. Also, some hedge fund managers apparently believe that there is money to be made as well.

From Bloomberg:

36 South Investment Managers Ltd., a New Zealand-based hedge fund firm set up by derivatives traders, will close its Black Swan Fund after it gained 236 percent in the last 12 months and start a fund that wagers on inflation.

So it isn't really news to anyone at this point that going long inflation is a trade to be considered. However, inflation expectations have traded down with the stock market. I think this is a good level to put this trade on as my model believes inflation expectations will return to normal as GDP growth improves. I think we are looking at about a 12 to 18 month horizon.

Can The Economy Get Worse?

Things are not looking good right now. The stock market is trading at lows not seen over 10 years, and the economy just lost 651K jobs. Downward revisions have been announced for January and February. But should we expect things to get worse?

While reading Bloomberg, Reuters, CNBC and other high frequency news sources it is often difficult to separate the noise from signal. I have therefore recoded a model I was using two years back while working at a large Wall Street firm. Needless to say I no longer work there. Back in January of 2007 the model was saying that the Fed would cut rates at least four times that year. That proved to be pretty much on target. At the time, the consensus view was that the Fed would raise rates to combat rising inflation. The Fed funds rate was one of the things the old model predicted. The new one, of course, is not able to predict Fed funds as that rate simply cannot go any lower. In June of 2007 the model predicted that economy would register close to 0% growth looking one year forward. That proved to be not far from the truth as well.

Here is the model output for 12 month forward predictions:

GDP: -.7%
Intial Unemployment Claims: 430K
CPI Core: 2.1%
ISM Manufacturing Index: 46
Consumer Confidence: 66

As you can see, this is a remarkable improvement over current conditions. GDP for Q1 is currently tracking at close to -5%. Initial claims for February 28 were 639K, ISM is at 35.8, and consumer confidence is at 25, while CPI core printed at 1.7%.

My interpretation of the model output is that in order for the economy to reach 0% growth by Q1 2009 we will need to see things deteriorate at a much slower pace. In other words, there should be a lot less cliff diving than what we have gotten used to over the past few months. Initial claims at 430K suggest that job losses will stop, however, the economy will not be generating many jobs either. CPI excluding food and energy at 2.1% suggest that we will see a bit of an uptick in inflation. It is likely that CPI proper will be higher than CPI core at the time.

It is a little unclear to me what the consensus view is at the moment. Some people say the economy will recover in the second half, and others say the recovery will not start until next year. Since there is no clear consensus the model can't be too far from the consensus view.

Can things get worse that this? The unemployment rate certainly will, but the economy should be contracting at a slower pace over the next twelve months.