Put on some puts

Stocks around the world have been enjoying what is a stealth rally over the past few months as the expansion of the Fed’s balance sheet has once again done its work in driving cash into stocks. But with this stock rally has come an improving economic performance in the US which has 10 year US Treasuries fretting as they continue to flirt with the 2% level as the run up to the FOMC interest rate announcement tomorrow morning Australian/Asian time.

Are stock markets overdone? Is the correlation to one for most stock indices a warning of risk? Is the record level of US Treasury puts as highlighted in the CFTC COT data over the weekend a sign that the bond vigilantes are stretched or are we on the verge of a break in the GFC market paradigm?

Here are a few charts that might be instructive.

Stock MArkets are at risk

There are clearly a lot of markets making multi year highs. If the recovery is real then there is no problem but if the markets recent performance is really just a reflection of the Fed’s balance sheet growth and bond buying program then the market might just be getting a little stretched.

I’m guessing puts are cheap at the moment. Might be a good day to buy some.

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  1. “if the markets recent performance is really just a reflection of the Fed’s balance sheet growth and bond buying program then the market might just be getting a little stretched.”

    I guess it depends on whether the rally is “in expectation” or “as a result” of the expanding Fed balance sheet (and that of other central banks around the world). If they are rallying in expectation then we might find that the next trillion (increase from $3 trillion to $4 trillion) is already priced in, but if markets are rallying as a direct result of the bond buying programs and increased liquidity then we may even see them continue to rally as the Fed expands it’s balance sheet.

    Amazing how a trillion dollars just rolls off the tongue these days with little thought given to the size of such an amount. A trillion here, a trillion there, soon you are talking about some very serious monetary debasement!

    • One of the reasons that we are talking in such huge numbers is that the Central Banks have been using the defective low interest rate / banking system debt generation mechanism.

      When it hasn’t worked to stimulate economic activity (apart from enriching the banks and pumping up stock prices) due to a reluctance by households and corporations to drink the cheap money Kool Aide the Central Banks have simply doubled up and forced rates lower.

      Now that this huge mountain of money pumped into the banking system appears to be finally generating some traction in the real economy (if only in the US) it will be fascinating to watch what happens.

      If households and corporates finally do get some of that old ‘debt fever’ happening will the Fed be able to suck all that QE back out of the system as easily as they think. They may be surprised how fast they will need to act once ‘debt fever’ is back.

      Of course, the old debt mechanism may remain broken and the current ‘green shoots’ are nothing more than some sickly wealth effect that will soon wilt.

      If that happens, we may find that some bright sparks in Central banking may decide that it is time to by-pass the low interest rate / debt mechanism and go straight to putting fresh cash in the hands of households.

      That version of QE is likely to have an immediate impact but will extremely dangerous unless all the existing QE money is not first drained from the system.

      Either way – central bank stimulation will eventually stimulate something – inflation?

      • I agree, it’s going to be very interesting to see how this great experiment plays out.

        Good chance that (as ZH put it earlier today): “At the end of the day, when the Fed decides to exit, they will not be able to put the liquidity ‘toothpaste’ back in the tube.”

  2. I think we need to be reminded of the coordinated synchronised QE / money printing / electronic capital injection of countries around the world, agreed to and formulated in the last six months of 2012. Hillary and Barrack Obama flying around the world to shake hands…….remember folks.

  3. Two month growth in stock prices (All Ords) is in the 92nd percentile based on post 1984 data from Yahoo, not including yesterdays rise.

    In terms of distance above 200 day SMA it is at the 85th percentile (not including yesterday’s rise).

    In terms of daily movements in the All Ords the 10 day average volatility is in the extreme low range being at the 5th percentile. (This measure of Volatility is normally highest during extreme bear markets.) So one would expect that an upturn in volatility is more likely to be expected

    These are levels from which there are often falls as the market slows growth rates and often falls up 5 to 8% in a correction.

    Sequestration in the US will be in the news in a few weeks and Europe has been having a very good run recently in spite of recessions and high unemployment continuing, so there is plenty of room for changes in news to drive reversal.

    While there could be more growth in the All Ords even over the next few months there’s certainly a rational basis for at least partially hedging against a fall.

    In the long term overview, based on an analysis of significant tops and bottoms we are about halfway up the ladder between median bottoms and median tops, and also between extreme bottom and extreme tops, but we are already jumping in the air above the top rung of the ladder between the lowest percentage falls and the lowest percentage rises, so even in a helicopter view there is some basis for being a little cautious.

    Based on 1998 to 2003 where I have looked at correlations between overbought against 200sma and against 2 month growth rates it is more likely a time to hedge or decrease exposure than to buy.

    Against that is the possibility that developed world government interest rates are at 2 to 3% for a long time, providing an opportunity for sharemarket PE’s to re-rate from say 15 to say 25 over time.

    I expect many investors are under invested and caught between fear of missing out and fear of a correction shortly after I buy. It takes a lot of nerve (and experience?) to have bought when the market is falling rapidly or consistently and the news is consistently of things getting worse and many have missed the opportunity from August 2011 to Dec 2012 when you could have bought below 4500 on the All Ords virtually the whole time.

  4. P/Es are getting stretched, surely? I don’t see Earnings doing anything like their stock prices – or am I wrong?

    In that case, doesn’t it mean that the gains are largely capital?

    In which case, doesn’t that signal a classic speculative market getting quite hot (too hot)?

    Other than QE induced and liberated cash, what has really changed?

    Just some thoughts,

  5. Yes I’d like to see the Fed’s exit strategy if inflation starts to spread like a bushfire. They’ll have something in place to deflate their balance sheet.

    The key indicator for the indices will be how the US housing market performs this year.

  6. Deus Forex Machina

    Yes I have to agree with Pingupenguin this bit of wisdom is a bit home spun.

    Everyone who takes a position in the market is a speculator – every one is trying to make a profit and the only difference is the time frame over which they expect to make said profit. Everyone is speculating.

    The notion of investing as different to speculating is simply wrong headed. Speculators invest and investors speculate. QED

    As for the Taleb reference PP is spot on. Anyone who sells uncovered options is playing a dangerous game – they will consistently make profits until they blow up when the little swan comes flying through their window.

    The notion of professionals and amateurs is also flawed. Options desks TRADE options which is a very different beast to simply selling them. They buy them too.

    And to the idea that if you are bearish you should sell calls that is also incorrect. If you sell a call then you get a small amount of cash and if you have a position and the market falls then your hedge is only limited to the income you have received. If on the other hand you buy a put you will significantly greater coverage on the downside should the market fall.

    Buying puts is the right kind of insurance in a market where there is still potentially considerable upside but risks to the outlook. That way you keep your position if the market rallies and are protected if it falls out of bed.