Author Archive for Surly Trader

Volatility is all About Liquidity

By Surly Trader

The S&P 500 tried to pull back yesterday, but as usual the late day trading pushed the loss to just 65 bps.  This has become the normal market.  In 2012, volatility puttered at 12.77%.  In 2013 it fizzled down to 11.07%.  YTD we have crept up to 11.73%.   These metrics tell you to expect daily gains and losses to be +/- .75%.  Very Exciting.

What does this market remind me of?  I would say the nearest example is 2004-2006 when volatility cycled between 10-11%.  What do these two periods in time have in common?  Extremely easy monetary policy provided by the Fed.

The most powerful chart to show you the impact of Fed provided liquidity plots realized volatility against the steepness of the yield curve as measured by the spread between the 10y and 2y treasury rates.  As the fed keeps the front part of the curve low through the Fed Funds rate, the steepness is held high.  A steep yield curve induces investors to borrow at cheap shorter rates and buy riskier assets to earn a spread.  Party on while the Fed provides the punch bowl.


(The current steepness of the yield curve is a great indicator for future market volatility)

The red line above is the steepness inverted, so higher numbers represent the curve flattening or the Fed taking punch away from the party.  Low numbers say party on.  The blue is the trailing 90 day realized volatility of the S&P 500.  When the Fed says to party, the volatility stays abnormally low.

Key point to make in this chart is that the red line is two years behind the blue line so the red line starts at 1/31/1977 while the blue line starts in ’79.   This implies that the tightening of monetary conditions or reduction in market liquidity takes about 2 years time in order for volatility to pick up.  If the curve can remain steep for another two years, then how large will the volatility dislocation become when the Fed does ease off the gas pedal?  Most punch bowls are provided for 2 years or less.  Right now we are in the 6th year of zero interest rate policy with a strong indication that they will maintain it well into 2015.  Maybe this time the volatility will come even before the Fed eases off the pedal?



S&P 500/Russell 2000 Spread

By Surly Trader

The spread between large cap and small cap stocks is a pretty simple metric, but it is hard to ignore historical correlation to corrections:



More interesting than the magnitude of the spread is that the Russell 2000 recently broke through its 200 day moving average while the S&P 500 was making new highs:


This same anomaly happened in July of 2007:



Draw your own conclusions.

Not Everyone Should Own a Home

By Surly Trader

On May 2, 1995 Clinton’s White House released the “The National Homeownership Strategy: Partners in the American Dream”.  You can download this fantastic historical document right here: National HomeOwnership Strategy PDF

They synopsis of the report and its desire can be summed up in the first few sentences:

For millions of America’s working families throughout our history, owning a home has come to symbolize the realization of the American Dream. Yet sadly, in the 1980s, it became much harder for many young families to buy their first home, and our national homeownership rate declined for the first time in forty-six yearsOur Administration is determined to reverse this trend, and we are committed to ensuring that working families can once again discover the joys of owning a home.

Well…guess what?  Homeownership was fairly range bound until politicians got their hands in it:




The political game continued with the Bush administration because of a political desire to make home-owning citizens (or possibly banks) happy.  We all know how that turned out.

It is extremely sad when you walk through the time series of events:

  1. Individual is tricked into buying an over-priced home with a non-amortizing or option ARM mortgage (most likely embedded with high fees)
  2. Loses home, down-payment, and money spent on the investment because housing prices drop precipitously and he/she lost job due to housing crisis induced recession
  3.  Institutions and wealthy individuals buy the houses in  (government subsidized) foreclosures at fire-sale prices
  4. Individual starts renting the same house from a “savvy” investor who continues to raise rental rates even though wage growth has been stagnant

Sounds like the plan worked out great…

Long-term Complacency

By Surly Trader

If you have been watching market news over the last few months, there have been plenty of articles talking about how low the VIX has gotten and how we are back to levels not seen since 2007 or earlier.  What they do not talk about is how the VIX is extremely short sighted.  At a one month measure, the VIX is looking through foggy scratched glasses while sipping on red bull.  What is more interesting to me is how long-dated options are pricing risk.  The volatility of the market over the next month is usually a bit easier to figure out than the volatility over the next year.  Now try to think about predicting the next 5 years…

Five year At-the-money implied volatility got north of 40% in the heat of the global financial crisis.  Ever since then the 5 year vol has been headed lower and most recently it has traded between 19-20% since the beginning of 2014.  This level has not been seen since 2007.  The fed has tamed the market.  The only real question is what happens when they let it go?


Anyone See a Correlation?

By Surly Trader

I have been told that China is slowing down. I have been told that with the US Fed tapering, some money is being drained out of the Emerging Markets and going to the United States. I have been told that the Emerging Markets will have reduced competitiveness that will benefit the United States.

I have no idea how any of this will end, but I can tell you factually that the S&P 500 has been very correlated to the performance of emerging market stocks and debt in the last few weeks. In particular, take a look at the rate action instigated by Turkey and its impact on the Lira along with its impact on the S&P 500. I would say they were pretty tightly correlated:



My guess is that the S&P 500 will find stability when the emerging markets find stability.  My guess is that stability will not be found for a few months and could provide an interesting market environment.  I will let the others pontificate on what will happen and spend my time analyzing what is actually happening.

GMO Calls for Another Ugly Decade of Equity Returns

By Surly Trader

Unlike the investment banks that prioritize making money off of their clients, GMO seems to think making smart investment decisions is the more important job.  On an annual basis GMO releases their 7 year forecasts for different asset classes.  Most recently they released a rather uninspiring forecast that puts US equities as one of the least attractive:



If you get a little skeptical about the forecast, take a look at their 10 year results from 1999-2009.  I can’t say that there are many who called it better:


Investors Love Obamacare

By Walter Kurtz, Sober Look

Some of the most unpopular policies often create tremendous opportunities. Take the Affordable Care Act for example. While the public is complaining bitterly about this legislation, some investors will be (or already have been) profiting handsomely. Venture capital firms for example are expected to rake it in by funding companies that provide healthcare-related software services (see story). At the same time, the equity markets have been bidding up the whole sector with the view that Obamacare will make healthcare firms more profitable. More subscribers and more people receiving care means higher revenues and outperformance for healthcare shares.

Healthcare vs SP500


Blue: healthcare index ETF, red: S&P500 ETF

By the way, is it time to take profits?

Bitcoin Mania Part II

By Surly Trader

There are three factual statements to be made about Bitcoin:

    1. It has created Millionaires
    2. It has captured the minds of millions who would like to become millionaires
    3. It will bust again

The last fact is that it is incredibly entertaining to watch.  It is a sideshow that represents market psychology in a small test tube.  The largest daily volume was about $67M which is a microscopic market in the investment world.



There is another market (and many others in history) that showed a similar trajectory with an ugly aftermath.  The most significant representation is gold in the late 70′s through the mid 80′s:



The more recent representation was silver and its quick march to $50:



My guess is that the size of the bitcoin market has allowed it to skyrocket at a faster pace, but it probably implies that it can go even further than the last Booms and Busts.

The World is Watching the Setting Sun

By Surly Trader

Japan has become our petri dish for central bank efficacy.  Much of the market action over the last few weeks has been driven from news coming from Japan.  When the Yen strengthens, markets fall and vice versa.  The question everyone is asking is whether central banks are heading down the right path or bound to lose control.

If you look at flows in the United States, the shift has been made towards floating rate or short duration debt and into cyclicals, small cap stocks, and even Japanese equities.  It seems that the 50 bps backup in interest rates has many investors feeling that interest rates are finally on their upward move.  You even have former chairman of Goldman Sach’s Jim O’Neill telling everyone to get ready for 4% 10 year treasury yields.

If the world is so filled with sunshine, why is the 10 year breakeven inflation rate in the United States falling:



And if the economy is counting on some support from a slowly recovering housing market, then how exactly will that housing market recovery react to a sharply rising mortgage rate:



To be honest I think we have just one elephant in the room and certain investors are reacting to short term technicals rather than the underlying over-arching issue:

Will Abenomics Work?

Look at the Yen, the Nikkei and 5 year Japanese breakeven rates.  They are all the same thing.  If Abe can’t ignite some inflationary pressure then the whole central banking foundation comes crumbling down:



Yen = Nikkei = Expected Inflation

Since the middle of May the Abe formula has been in doubt.  If the Abe formula is in doubt for Japan, then it certainly should raise flags for central banks around the world.  Japan is just much further down the path of deflationary destruction.  Let’s just hope that Japan’s 3.5% reported Q1 GDP and later revised upward to 4.1% (because the 5/15 number didn’t seem to impress) is real.  Otherwise it might just be a long summer and fall trading season.


Volatility is Smiling

By Surly Trader

The Credit Suisse Fear Barometer has dropped like a rock since the beginning of May (see figure 1).

This has little to nothing to do with implied volatility dropping and everything to do with the shape of the implied volatility curve.  In this case, the 1 month 10% out of the money call option implied volatility has risen from about 12.4% to 14.4%.  This extra 10% out of the money call premium has made 10% out of the money puts more affordable even though the put cost hasn’t changed (see figure 2).

This might get at the renewed sense that we are going to have binary outcomes in the near-term.  Either the Fed is going to reinforce its commitment to quantitative easing and the market shoots up OR the Fed is going to hint at a pull-back in quantitative easing and the market is going to fall off a cliff.

This manic behaviour definitely played out today in the S&P 500.  When the Fed indicated its commitment, the market shot up in the morning.  When the thought sunk in that the Fed might prematurely scale back its purchases, the market pulled back sharply (see figure 3).

Up is down, right is left.  Nothing matters except for how long and how much QE is going to be pumped into the system.  Economic news only influences traders’ thoughts on whether it will shorten or lengthen the life of quantitative easing.  The only thing that can be certain is that before all is said and done, at least one bubble will be inflated and at least one bubble will burst in the aftermath of our central bank experimentation.  Japan seems to be a likely and volatile candidate.


(Figure 1)


(Figure 2)


(Figure 3 – 2.3% range doesn’t quite compare with silver but we are getting there)

Where is the Volatility?

By Surly Trader

Once again we find ourselves in a market of complacency.  The VIX closed at 12.66 today which puts it in about the 13th percentile since 1990 (see figure 1).

What is fun to notice in this all-time high flying market is that the 20 day trailing volatility is 15.6% while the 10 day is 9.8% and the 50-100 day are 11-12%.  So basically the VIX is telling you that the little risk flare a few weeks back was nothing but a fluke (see figure 2).

So riddle me this – Is the 10 year treasury at 1.76% telling me

  1. that bonds are an inferior investment and we should all be plowing into equities?
  2. that QE is an infinite cure to the common cold and interest rates no longer matter (so plow into equities)?
  3. that a 1.76% yield combined with 1.5% inflation might just predict a rather sour economic environment

Thank you Ben and fellow global central bankers, you have succeeded in luring the sheep back into the chase ?for yield in one final and glorious conclusion.


(Figure 1 – Nothing to see here!)


Risk Flare Ignited

By Surly Trader

Investors often explain to me that volatility should be very low because of the abundance of liquidity in the markets which is directly due to easy monetary policy across the globe.  My immediate response is that the liquidity is there in abundance until it is gone.  Long dead are the days when human market makers begrudgingly bought into sharp down-drafts in risk assets in order to provide liquidity.  In the “modern” financial arena, you can hear a pin drop on the bid side of the order book when a sharp correction occurs.

It only takes one day for the market to change its mind.  There are three rather noticeable dislocations in asset classes.

1) VIX

Today we experienced a 43.2% increase in the VIX.  This is in the 99.93 percentile since its inception in 1990:


Graphically we can see that the change has limited company:


2) Oil

The downward spiral in crude prices over the last two days pales in comparison to the jump up in the VIX.  The two-day move of -5% only gets into the top 95th percentile of observations since 1983:


3) Precious Metals

Anyone levered and long in the precious metals space is crying uncle.  Gold sold off like a banshee over the last few days and even gave bitcoin a run for her money:


Just how bad was the two day 13.67% drop in Gold?  Beat out the VIX at the 99.98 percentile since the beginning of 1975:


It never seems that this kind of volatility happens in isolation.  Therefore we might just be in for an interesting spring and summer…

From the S&P 500′s standpoint, the trend was broken and there is little support remaining.  1550 might be bounce, the 50 day moving average at 1540 as well, but it seems like 1525 is in the gun sites:


Cyprus: A Prototype?

By Surly Trader

With a slight shrug, the markets seem to be just fine with the deposit seizures whereby the EU is raiding private bank accounts within the small country of Cyprus.   The initial talk was to tax every depositor under €100,000 at 6.75% and those over that amount at 9.9%.  And who should care with a tiny economy that makes up just .2% of the Eurozone GDP?  You should.

It turns out that just a few weeks ago the finance minister of Cyprus himself would never have believed this would happen:

Cyprus’s new finance minister on Friday ruled out a haircut, or imposed losses, on bank deposits to ease a financial bailout from international lenders, now stalled amid worries about debt sustainability.

Really and categorically – and this doesn’t only apply in the case of Cyprus but for the world over and the euro zone – there really couldn’t be a more stupid idea,” Michael Sarris, who took over his post on Friday, told reporters.

The outcome of this “tax” really no longer matters.  The sad fact is that even Germany understands that, “Last Euro-Crisis Taboo (has been) Broken“.

What is stopping every depositor in Portugal, Spain, Italy and Greece from pulling their money out?  Why would you leave it in when the rules are changed overnight?

The worst case has always been a Europe wide “run on the banks”.  Let’s just see how much fuel they added to the fire.

From the business daily Handelsblatt in Germany:

“The currency union has committed a breach of trust. It weighs especially heavy because the euro states have already secretly been rehabilitating their economies at the expense of depositors. Low interest rate policies help bring down the national debt, but at the same time they gradually deplete the balances of savings and money market accounts. The pensions of many citizens are also dwindling.”

“Anyone who now believes they shouldn’t be interested in the fate of individual depositors on a remote Mediterranean island is mistaken. Cyprus sets a precedent. What happens there can also happen elsewhere. In Spain and Ireland, bank bailouts have allowed the national debt to explode to an unsustainable level. There, the euro zone could see tapping into bank accounts as the next step. In principle, no European depositor can remain assured that their bank balance will remain untouched — even in Germany.”

A Day in the Life of the VIX

By Surly Trader

Light volume, boring trading, reaching for all time highs on the S&P 500 and the VIX tumbles into the close:

Where does this drop put us in history?  Oh, just back to February 2007:

The option players don’t buy the euphoria though as the Credit Suisse Fear Barometer (CSFB) Index indicates:

Which side of the fence are you on?

Where Have all the Market Makers Gone?

By Surly Trader

The market can often seem like it has a case of Memento.  One day we are trading euphorically upward (like today) and the next we see a panic stricken sell off.  I have made a point in the past that I believe the positive (or negative) feedback loops are stronger in modern markets, that high frequency trading does not replace human market makers, and that the removal of the uptick rule might be the dumbest thing the SEC has ever done (that’s saying quite a bit).  Instead of spouting off opinion, it might be worth a little bit of analysis.

If we look at 20-day or 1 month realized volatility of the S&P 500 it is easy to dig into the extremes.  In the chart below it is simple to identify A) the great depression, B) the 1987 crash and C) the global financial crisis of 2008/2009:

Can you spot the heart burn?

Aside from the obvious spikes, you could also make the case that since the late 1990′s we have experienced higher volatility levels that are higher than any aside from the great depression.  One thought strikes me as particularly interesting: would you not think that there is more liquidity in today’s electronic and global markets than during the great depression?  Would this not imply that less liquidity in the 20′s and 30′s could have exacerbated the volatility in the markets as there were fewer buyers and sellers to jump in front of moving freight trains?

Let us take a different approach and think about volatility in a slightly spread oriented way.  The first sentence of this post struck at the bipolar nature of today’s modern market.  In times of calm, the market seems toocalm.  In times of stress, the market seems too stressed.  If we look at this same data and take the difference between the 75th percentile of 20-day volatility observations and the 25th percentile of volatility observations we get a slightly different picture:

The data shows that the middle band of volatility outcomes has become extremely bipolar with 2008 leading the pack.

Let us write down a list of the possible reasons in no particular order:

  1. Lack of human market makers
  2. Abundance of computerized programs looking for mean reversion in calm markets and momentum in moving markets
  3. Abundance of hedging from Insurance companies, Banks, Pension funds etc.
  4. Removal of an uptick rule
  5. Federal reserve zero interest rate policy
  6. Leverage

I do not have the answer, but it is probably a combination of all of the above.