A couple of very interestng stories on Bloomberg today, regarding some long term directional bets by what I assume to be big players. Effectively it’s the same “dollar inverse” trade but in reverse …keep in mind dollar down = stock market up is not the traditional relationship, it’s just something that has taken a life of its own as Ben Bernanke has provided an unlimited fire hose of US dollars to make us all feel better via inflated asset values. There are some fascinating tidbits in these stories.
First, ‘Options Signal Stock Peril as Analysts See Profits‘ – this is an interesting one, as by the time analysts form consensus about something, it’s generally time to do the opposite. The same analysts hiding in bunkers this spring now are giddily raising estimates across the board in out years. There incorrect assessments of how valuable chopping so many Americans from the payrolls would be to corporate bottom lines led to masses of “better than expected” beats during earnings season, but like any good momentum stock – eventually the analysts race to “catch up” and place a target far too high. That’s when you get disappointment – we should be setting up for such a scenario by Q2 or Q3 2010.
Forecasts for the fastest U.S. earnings growth in 15 years are failing to convince options traders that the Standard & Poor’s 500 Index will extend its biggest rally since the 1930s. S&P 500 options to protect against declines in stocks over the next year cost 22 percent more than one-month contracts, the highest since 1999, data compiled by London-based Barclays Plc and Bloomberg show.
The gap shows concern that analyst estimates for record earnings by 2011 may prove exaggerated, endangering an advance that pushed the S&P 500 up 63 percent since March.
The last time the average gap between one-year insurance and 30-day contracts was higher was five months before the S&P 500 began a 49 percent plunge in March 2000 during the collapse of the Internet bubble. (now that is a fascinating item of information)
Not that history is identical but 5 months prior to March 2000 was the giddy November 1999 when I remember the market being so easy, that even a “throw a dart at any technology stock” doofus such as myself was minting money with his eyes closed. And it got even easier in the next few months as the NASDAQ went parabolic. I was a genius… we all were. Shooting fish in barrels. So 5 months from now would be roughly April 2010, just about the time the Fed might consider changing one little word in their statement about “free money forever” which might be the cause for a stampede in the other direction … we’ll see.
One-year implied volatility, which measures the price of options, on the S&P 500 has jumped to 24.16, or 4.42 points higher than the level for one-month contracts, Barclays data using 10-day moving averages show.
Option prices are rising on speculation the Federal Reserve will lift interest rates in 2010 or risk stoking inflation.
“The market is enjoying what some are calling ‘the calm before the storm,’” said Justin Golden, a strategist at New York-based Macro Risk Advisors LLC, which advises institutions on derivatives trades. “Future expectations of volatility far outweigh the present. This spread paints a picture of the extreme uncertainty premium that exists in future equity prices.”
“Mutual funds, hedge funds, pensions and endowments were scared stiff, but now they’ve regained their appetite for risk,” said Jean-Marie Eveillard, senior adviser to the $8.6 billion First Eagle Global Fund in New York and a finalist for Chicago-based Morningstar Inc.’s fund manager of the decade award for non-U.S. stocks. “It’s a warning sign because everyone who wants to be invested already is.” (bingo – we are now reaching the stage of complacency where even those bearish have thrown in the towel and are “going in” because “the market just won’t go down” – might last 2 weeks more, 2 months, 6 months… you never know when it ends but usually quite spectacularly)
Traders in the $3.2-trillion-a-day foreign-exchange market are paying the highest prices in more than a year to protect against a sudden rebound in the dollar after its worst annual performance since 2003. Dubai’s effort to delay debt repayments reminded traders how the U.S. Dollar Index surged 16 percent in the two months after the September 2008 collapse of Lehman Brothers Holdings Inc. when investors sought a haven from the turmoil and poured money into U.S. assets.
“American investors have a lot of exposure now to foreign markets,” said Mansoor Mohi-uddin, the chief currency strategist at Zurich-based UBS AG “If investors become risk-averse again, which happened last year due to Lehman’s bankruptcy and could happen now for a whole host of reasons, they are likely to go into less risky assets like U.S. Treasuries, which would help the dollar.”
Now it might seem ironic that the US, which was the cause of all the global issues we’ve seen the past 5 years, would still be seen as the safe haven but old habits take a long time to kill. With the most liquid bond market, it makes sense that this is where investors fled to, but as we stated in 2008, in no time in history did the country that caused the issues see a flight of capital INTO their country. But that is the benefit of the reserve currency and many decades as top dog. This was a trade I (and most others) completely missed predicting, the “go long US dollars and Treasuries” that was a boon in 2nd half 2008. We saw a 1 day blip 2 Friday’s ago with a minor issue like Dubai… what happens if its Greece next time? [Nov 27, 2009: UK Telegraph – Greece Tests the Limits of Sovereign Debt as it Grinds Toward Slump] Do we just assume Germany errr the European Union bails them out like Super Ben does for everything stateside? Or (can’t imagine it) the UK? [Dec 1, 2009: Morgan Stanley Lists UK Sovereign Debt / Currency as Potential “Fat Tail” Risks for 2010] Who bails them out if and when? As every trader on Earth is in the same “short dollar” trade, the explosion higher in the dollar would cause some epic dislocations – again… and we are right back to the “fun” of 2nd half 2008 and early 2009.
In the greed that has now already (how short our memories) overtaken the market, (some) people are once again not allocating for these outlier events. The moments which over the course of 20-30-40 years can destroy your portfolio. Hence it seems worthwhile to have some portfolio insurance in “long dollar” instruments (which we do have) – or anything else that that bets against the ‘consensus’ – even if that insurance is never needed. Because as we saw with Dubai Friday (a relative blip) waking up to a -500 Dow futures market in some larger event in the future won’t allow you to position yourself for the “out of the blue” moment. Will it be tomorrow? in 3 months? 3 years? or 13 years? Who knows. But it sounds like some “big money” is protecting against “sooner rather than later”.
So it gets technical here but just follow through to the conclusions below:
While Intercontinental Exchange Inc.’s Dollar Index fell to a 16-month low last month, implied volatility on three-month call options granting the right to buy the greenback versus the euro exceeded that for options to sell it by 1.61 percentage points.
The so-called 25-delta risk-reversal rate, which was flat as recently as October, hasn’t shown such high relative demand for dollar calls since hitting a record 2.595 percentage points in November 2008.
When the implied volatility of dollar calls exceeds puts, like now, the gap is expressed as a negative number, which would be minus 2.595 percentage points. The rate touched minus 1.67 percent today.
Investors are waiting for “the BOB event, a bolt out of the blue,” said John Alkire, the chief investment officer at Morgan Stanley Asset & Investment Trust Management in Tokyo. “The world had a mini-BOB,” when financial markets tumbled after Dubai announced plans to restructure some of its $59 billion in debt.
The Dollar Index had its biggest two-day gain in a month on Nov. 26-27, rising 1 percent, as Dubai’s proposal to delay debt payments shook investor confidence by risking the biggest sovereign default since Argentina’s in 2001.
Investors are also wary of the global economy falling back into recession with U.S. unemployment above 10 percent for the first time since 1983, non-performing U.S. commercial mortgage loans as measured by Moody’s Investors Service rising to 8.3 percent and the potential for stocks to fall after the steepest rally in the Standard & Poor’s 500 Index since the 1930s.
Record-low interest rates in the U.S. have encouraged investors to borrow in U.S. dollars and reinvest the proceeds in countries with higher ones, such as Australia and New Zealand.
“People saved money in the past by not insuring themselves, which proved to not be a great trade,” said Nick Parsons, head of markets strategy in London at NabCapital, a unit of National Australia Bank Ltd., the country’s largest bank by assets. “There is plenty of incentive and opportunity to hedge now. People are much more willing to buy insurance.”