A healthy dose of risk aversion returns to US equity markets

With the so-called "currency wars" escalating after Beijing's recent devaluation and China's growth stalling, investors have suddenly become quite jittery. We are now seeing significant signs of stress in US equity markets.

The S&P500 index finally broke out of its trading range,

Source: barchart

... and the VIX (implied volatility) index jumped to levels we haven't seen since late 2011 - the height of the Eurozone crisis.

Source: barchart

The VIX curve has become inverted, which generally indicates a heightened level of risk aversion.

Moreover, gold prices and the euro have risen materially and became more correlated over the past few days, indicating a rising "risk-off" sentiment. Both gold and the euro are viewed as "safe haven" assets.

It's important to point out that risk appetite has been declining even prior to the recent selloff. Here are some indicators:

1. Investment advisors are cutting back equity exposure (as shown by the NAAIM index below).

Source:NAAIM

2. Money market inflows have spiked.

Source: @pkedrosky

3. Single-stock put option activity has risen.

4. Hedge fund managers have been picking more defensive shares.

 Source: @vexmark

5. Leveraged finance markets have been under pressure for some time. The chart below shows the SPDR Barclays Capital HY Bond Index ETF (JNK).

Source: barchart

While these indicators point to rising stress in the markets, in the long run this is actually quite positive. A healthy level of risk aversion is vital for a more rational approach to asset valuation in order to limit the formation of financial bubbles,


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HY spreads now positively correlated to treasury yields

Here is further evidence that in this environment treasuries are driving "risk asset" valuations. Corporate HY bond spreads are now positively correlated to treasury yields. That's quite unusual because traditionally when treasury yields shrink, spreads rise (negative correlation).

Based on Merrill HY Index

By not allowing treasury yields to rise, the Fed is artificially suppressing HY spreads (as well as other "risky" bond spreads). The corporate market is therefore heavily dependent on stimulus, making any attempt to normalize monetary policy increasingly difficult.

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Tail risks lurk in the shadows. Fiscal cliff is out in the open.

Merrill conducts a periodic survey of US institutional money managers. One area the survey focuses on is a set of questions on the so-called "tail risks", the less probable but potentially devastating events that negatively impact financial asset valuations. Here are the survey results from September and October of this year.

Source: Merrill Lynch/BofA (click to expand)

The US fiscal cliff is clearly on people's minds and is quickly becoming the dominant concern in the financial community. If this survey were conducted today, the percentage of participants who would view the upcoming budget cuts and tax increases as the main risk to their portfolios would increase sharply. In fact, based on Google Trends, the public's concerns about the US fiscal cliff have spiked recently.

Google search trend for "fiscal cliff"

But once certain risks become this widely "respected", they can no longer be called "tail risks". In fact as we saw in today's equity markets, these risks are already being priced into the markets.

Tail risks are usually those events that are not fully priced, risks that are ignored, sometimes leading to formations of asset bubbles. What would be an example of such a risk these days? One potential candidate may be some of the US bond markets, for example credit (see discussion on corporate credit).

Below is the famous CS Risk Appetite Index shown together with its US Credit Risk Appetite sub-index. US credit risk appetite is approaching what CS refers to as the "euphoria" level.

CS: - US Credit Risk Appetite is a whisker away from Euphoria while Global Risk Appetite appears range-bound, close to its long-run average of about 1. US CRA being this close to Euphoria suggests caution- riskier corporate credit seems overbought both in absolute terms (yields are near record lows) as well as relative to safer credit. The last time the gap between Global Risk Appetite and US CRA was this large was August 2011, and it did not persist for long.

Source: Credit Suisse

Interestingly, the Merrill researchers who conducted the institutional investor survey (above), list "bond market bubble" as one of the key tail risks. And for those who still don't think we have a bond market bubble (and many investors don't), just take a look at the net fund flows in the last few years (bonds vs. equities).

Source: Merrill Lynch/BofA

It doesn't mean that this bubble in bond markets can't persist for much longer. The US housing bubble lasted for years. Clearly the Fed continues to provide support to spread products for now, which makes the probability of a major spread widening quite low (thus a "tail risk").

When looking for "tail risks", it is therefore not helpful to zoom in on areas where the investment community and particularly the public is already heavily focused, such as the "fiscal cliff". The time for that was back in April and May (see post), possibly even earlier. Instead one should look at the less probable events that most investors are now simply ignoring.

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Popping the rare earths bubble

In recent decades financial bubbles have been plentiful. From the US housing to the global uranium markets, bubbles seem to be simply inevitable (and generally can not be prevented by regulation or other government interference). In fact bubbles occur even in simulated (experimental) markets (see this paper). Most major asset classes experience a bubble periodically. The tech bubble of the late 90s for example has been one of the better known ones in the equity markets.

NASDAQ Index

Very few have been as spectacular as the one in the so-called rare earth metals that are used to manufacture all sorts of equipment, including LEDs, smartphones, and motors. The rise in prices was triggered by China's policy of limiting exports, creating a perceived shortage. From there hoarding and speculation took hold. And as often happens in commodity markets, the bubble burst almost as violently as it inflated.

Reuters (Scott Barber): - As prices soared, new mining projects made it on to the front burner, and some of these are likely to come onstream before the end of the year, including an expansion to Molycorp’s (MCP.N) California operations. China remains by far the world’s largest producer of these materials, but as new supplies elsewhere hit the market while demand remains little changed, China itself also is changing its tune and has announced a higher export quota.

To put the magnitude of this bubble in perspective, the chart below compares the price action of 3 rare earths with gold and silver, which have also appreciated materially over over the same period.

Source: Reuters

And price declines are continuing. Nations and companies are simply figuring out how to reduce dependence on many of these materials - for example Dysprosium, a metal highly valued for its ability maintain magnetic properties under high temperatures (such as in motors). Japan in particular has been under pressure to adjust because of its loss of supply due to recent tensions with China, the largest producer.

The Asahi Shimbun: - TDK Corp., which supplies magnets for motors, has developed a magnet where dysprosium is painted on its surface alone rather than being mixed into the entire magnet body, reducing dysprosium use by half. The company plans to start producing the magnet for automobiles in October.

In February, Panasonic Corp. introduced equipment to extract magnets made of neodymium, another rare earth element, from used home electric appliances at its home appliance recycling plant in Kato, Hyogo Prefecture. The neodymium will be reused in air conditioner compressors and in motors for drum washers and other products, Panasonic officials said.

Honda Motor Co. plans by year-end to start extracting rare earths from nickel-metal hydride (NiMH) batteries used in hybrid vehicles. The automaker's dealerships will collect NiMH batteries from disused hybrid vehicles, and a plant belonging to ferroalloy manufacturer Japan Metals and Chemicals Co. will dismantle them to extract rare earths. Honda will then use the collected material in new hybrid vehicles.

The industry ministry estimates domestic demand for rare earths dropped from 31,000 tons in 2010 to 23,000 tons in 2011.

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Bail-in provisions will exacerbate run on banks, drive German asset inflation

This Sober Look post discusses the reality of unsecured EU bank bonds that are expected to have zero recovery due to the so-called "bail-in" provisions. Should a bank were to become "insolvent", these provisions will allow the regulators to force orderly defaults, subordinating these bonds behind any government bailout funds. But because most bank assets that would have value in a liquidation are already pledged (particularly in the periphery) to the ECB under the LTRO programs, there will be nothing to recover under these unsecured claims. Unsecured bank bonds have basically become equity with no up-side. The provisions will essentially put an end to most EU banks' ability to issue anything but covered bonds.

FT: - Sweeping reforms to shift the burden of rescuing failing banks from taxpayers to bondholders are to be unveiled by the European Commission, despite fears it will further rattle nervous bank investors.

When a bank is deemed to be failing, regulators will win extensive powers to write down non-guaranteed deposits and senior unsecured bondholders, according to draft proposals obtained by the Financial Times.

While the broad thrust of EU bank resolution reforms are well known, its publication has been delayed for more than a year over fears the so-called “bail-in” tools would make it even harder and more expensive for banks to raise money.

What's more, large depositors such as corporations, trusts, pensions, asset managers, insurance firms, etc. will have to view their cash at banks as unsecured lending to these institutions.

Within the euro area these bail-in provisions will simply drive bank clients to move balances to German banks and into German government paper, further exacerbating TARGET2 imbalances and run on periphery banks. This flight of capital is even starting to drive German asset price inflation.

Pimco: Evidence so far points to accelerating asset price inflation in Germany rather than consumer price inflation. Capital flight and their “safe haven” status have inflated the prices of German government bonds. Concerned about the stability of the euro, Germany’s savers are shifting their money into real estate. German residential house prices and rents rose by 4.7% last year, the fastest increase since 1993’s reunification boom. So far, Germans are not leveraging to buy houses. Growth in German mortgages is paltry at just 1.2% per annum according to the ECB as of December 2011, but in our view all ingredients for a debt-financed house price boom are there. Distrust in the euro is rising, German households’ debt level is low, as are interest rates and unemployment. The ECB’s monetary policy is too loose for Germany’s domestic conditions, just as it was too loose for Spain and Ireland in the early years of monetary union when Germany’s economy was weak.

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The Black-Scholes pricing formula had nothing to do with the crisis

Ian Stewart published an article today in the Guardian describing how Black-Scholes contributed to the 2008 financial crisis. He concludes that although the option pricing formula is not to blame, its abuses contributed to the crash.

The Guardian: Was an equation to blame for the financial crash, then? Yes and no. Black-Scholes may have contributed to the crash, but only because it was abused.

This is not new. Others have been blaming option valuation techniques for the crisis because it's all about the scary complicated derivatives that were not priced properly due to bad assumptions.

Amazingly this misconception is widespread. There is this image of traders sitting around, making some volatility assumptions that are sometimes incorrect, then plugging these numbers into their formula to come up with the price. Many financial textbooks actually describe it in such a way. And the magic "complexity" of Black-Scholes makes traders go mad in their pursuit of profits. Bad inputs into the formulas make the markets go bad...

The Guardian: The Black-Scholes equation was based on arbitrage pricing theory, in which both drift and volatility are constant. This assumption is common in financial theory, but it is often false for real markets. The equation also assumes that there are no transaction costs, no limits on short-selling and that money can always be lent and borrowed at a known, fixed, risk-free interest rate. Again, reality is often very different.

As an academic, Dr. Stewart probably never traded an option. Dr. Stewar and others may be surprised that option prices are not determined by the Black-Scholes equation. In fact options and other derivatives were traded long before the Black-Scholes formula came about. As is the case with all markets, it is the markets that determine prices, not an equation.

Option pricing formulas are used to compare relative value of options - just as other valuation formulas are used to determine the relative value of other assets. The markets are in fact quite efficient and to the extent there are flaws in theoretical descriptions of price behavior of assets, the market corrects for it. The chart below shows the implied volatility for different strikes of SPY ETF options. By implying a higher volatility away from the current price, particularly to the downside, the market is clearly pricing in "fat tails" of the price movement probability distribution, therefore adjusting for any imperfections in the formula. All option markets tend to exhibit this type of behavior - all adjusting for imperfections in the mathematics describing price behavior.

SPY ETF Option "skew" (Bloomberg)

To demonstrate the madness around Black-Scholes, consider a simple formula used to value a perpetuity.

If one knows the cash flow and the interest rate, one can then obtain the present value of an asset that pays a constant amount in perpetuity. An example of that would be a rental property. Now ask any person who buys and sells rental properties, would they rely on this equation when valuing properties? Unlikely. However they could use it to determine the "implied" discount rate and compare it across properties to get an indicator of relative value of one property vs. another or properties in one geographic region vs. another, etc. As rates decline, one could for example use this equation to argue that rental properties become more attractive - which actually hasn't been the case recently. In fact in recent years the implied r in this equation has been high because of higher implied risk in rental properties. But nobody in their right mind would use this or any other pricing formula by itself to buy and sell properties.

The same applies to the bond yield/spread formulas. The market determines bond prices but the yield and spread formulas allow one to compare bonds with different coupon and other contractual differences. Implied volatility in the Black-Scholes equation is in that sense the same as the yield/spread measure for bonds. It is used to determine relative value, not to come up with a price at which one wants to transact. For convenience many markets quote yield, spread, or implied volatility when trading, simply because the translation from these measures to price has become standardized - i.e. all market participants will obtain the same price using these inputs.

To argue that Black-Scholes contributed to the crisis is like saying the bond/spread formulas or the perpetuity formula above contributed to the mispricing of bonds and properties, thus causing the crisis. Bonds, properties, and options for that matter were priced going into the crisis by the same forces that priced tulip bulbs 1630s in the Dutch Republic. Clearly there wasn't a formula to price tulips back then. Financial bubbles can occur in any market and they will happen again in the future. The Black-Scholes formula or any other mathematical expressions describing price behavior have nothing to do with it.

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Implied Real Rate tells a story of loose monetary policy and asset bubbles

There are numerous ways to measure how easy the monetary policy is at any particular time. Quantitative easing aside, one can look at the overnight rates as the simplest measure of stimulus levels. The Fed Funds rate fluctuating between 12 and 25 basis points feels sort of accommodative.

Of course a better measure is the real rate, which is the nominal overnight rate less inflation. The lower the real rate the more stimulus is being provided. Unfortunately inflation in the form of CPI releases is a backwards looking indicator. Any monetary policy is meant to set the stage for the next few years and should be more reliant on forward looking indicators of inflation. One such indicator is the inflation rate implied from TIPS. There are clearly issues with both TIPS and the CPI measure itself, but the implied inflation measure gives a decent forward looking indicator implied by the markets.

Many economists view low real rates that exist today as restrictive because of tighter credit in the current environment. However the market implied inflation rate already takes into account the current and the expected credit conditions. Therefore the Implied Real Rate is in fact a more holistic indicator of how loose the monetary policy really is as viewed by the markets.

Let's define the Implied Real Rate as follows:

Implied Real Rate = (Fed Funds Effective rate) - (inflation rate implied by the 10-year TIPS).

The Implied Real Rate is now at about -2%, the lowest level since TIPS have been first issued. That certainly feels quite accommodative, but let's compare the situation to the last cycle. In particular, let's look at how accommodative policy impacted asset levels - here we use S&P500. The last big drop in the Implied Real Rate was back in the 2002 - 2004 period, which launched the famous liquidity driven asset bubble.





Here is what the measure looks like right now.





Given the similarities, is the accommodative monetary policy that is currently in place setting us up for another crisis? Is the Fed behind the curve? Many argue that there will be time to take the liquidity out. By then however it may be too late:

From HSBC:
The remarkable thing about such liquidity-driven asset bubbles is their long-cycles, underlining the eventual potency of loose monetary policy. Also, successive monetary tightening over the course of the bubble has apparently little impact: once the financial accelerator goes into full throttle, it takes aggressive tightening to pop the bubble – and, more often than not, policy-makers are reluctant to step up for fear of bringing down the house.

To illustrate that effect, in 2004 the monetary policy did in fact begin to gradually get tighter, as the Implied Real Rate began to rise. But as HSBC points out above, this gradual tightening is (and in fact was) ineffective, and asset prices continued to rise unabated.




Mr. Bernanke, maybe it's time for action.

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China's state sponsored economic bubble

A while back we discussed signs of an asset bubble building in China. Let's now take a glance at China's government contribution to this bubble formation. What's particularly striking is the amount of waste involved as the Communist regime's central planning pushes through massive infrastructure projects. Many are developed without considerations for returns or the ability to pay back loans. The government can force state banks and other institutions to keep money losing businesses running, while they develop new ones. It's a form of stimulus that generates rapid short-term growth, but is not necessarily sustainable and is not likely to stimulate domestic consumer demand in the long run.

Example 1: Office real estate:


Example 2: The World's Largest Shopping Mall (Click picture to watch POV video):



hat tip Patrick

People's Bank of China tries to prevent asset bubble

Here is a quick follow-up to our post on China called Fresh signs of China's asset bubble. Looks like the Chinese government is taking this potential bubble issue quite seriously. They've been forcing banks to significantly cut lending to reduce all the liquidity making it's way through their economy, manifesting itself in asset inflation. People's Bank of China even issued a low yielding note and forced some banks to buy it to limit cash on their balance sheets.

It worked. Here is the recent lending amount statistics from China:



This reduction in liquidity is showing up in the stock market as well.



This was a timely and prudent move on China's behalf, as the asset bubble was clearly beginning to build. Let's see if they can maintain the discipline going forward.

Fresh signs of China's asset bubble

As we discuss earlier (Pegged renminbi will be hard to internationalize and Asia, the next big bubble), China's loose monetary policy is starting to manifest itself in signs of an asset bubble. Part of the reason for the policy is driven by the need to keep the renminbi from appreciating (unsterilized foreign exchange interventions). As we know from the US experience, bubbles can grow for prolonged periods of time. Once an asset bubble gains momentum however, even a more restrictive monetary policy may not be able to curtail the growth.

Below are some examples of this excess liquidity making it's way from the banking system into China's economy. The first two illustrate the rapid rise in lending activity, while the second two are indications of the frothy equities markets.

1. Loan activity: From the FT:

...banks advanced Rmb5,840bn ($855bn) of new loans in the first five months, almost triple the amount a year earlier. As for June’s lending, at $220bn it was a blockbuster as banks pumped up their quarterly loan numbers, just as they did in March (to $280bn).

2. Interbank lending activity. In the US (and Europe as well), banks are only now starting to actively lend to each other. However the liquidity is "trapped" in the banking system, and so far is not making it's way out into the real economy, i.e. there is no "multiplier effect". That is why USD interbank lending rates (LIBOR) have been dropping. In China, the interbank rates have gone up, indicating that banks are moving liquidity out into the real economy, creating demand for interbank loans. The multiplier effect is definitely in play.





3. The liquidity is making it's way into the equities market: The Shanghai Stock Exchange volume chart below tell the story.




4. Frenzied IPO activity: From the NY Times:

China State Construction Engineering, whose $7.3 billion initial public offering last week was the world’s biggest in a year, jumped 90 percent to an intraday high of 7.96 yuan, or $1.17 — more than analysts had expected — as investors ignored the company’s relatively high valuation to pile into the stock on the first day of trading.
...
China Construction opened trading at 6.70 yuan Wednesday, a level that valued it at 42 times its forecast 2009 earnings per share.