Ok yesterday’s call on the VIX was great , no need to say thank you. Anyhow I thought it would be timely to look at the Investment Company Institute data and that it would be interesting to visualise the data and to look at the effect of risk on investors preferences for the assets classes in time of market stress. The following show the inflows/outflows in bonds, equity and hybrid US mutual funds. Quite clearly Mr Bernanke speech dented the appetite for bond products but despite appetite for equity product abating it did not really substantiate significant outflows there. The charts below show the monthly inflows / outflows relative to their median and a 95% interval of confidences. The charts on the right just give a distributional representation of the monthly data.
The chart below shows the T-Stat (i.e. the level of significance) of the inflows across 4 different time periods. The outflows in bonds switched to negative over the last 3 months but equities and particularly holdings in international have hedl well.
In the below I used a bit of code wizardry to look at what happen when market risk increases. I use the VIX as my risk metric. When markets went “postal” in October 2008 it was quite clear then US equities suffered the most outflows but the bond market remained quite resilient as the fed came to the rescue.
Clearly the financial volatility has not reached levels experienced in the last quarter of 2008 and there is clearly no dislocation of the financial system this time. So no reason to panic. The chart below shows the Bonds were the main recipient of the market aversion but all this is very tame by any means.
My thought is that as the market normalise and comes to terms with the Fed policy we will see further sell off in the bond markets and that the proceeds will be reinvested in the equity markets as the shift in the Fed monetary policy will be driven by better economic fundamentals….no need to go into cash this time….
True enough equity markets have been somehow volatile over the last month and I have to admit that my equity view has been compromised on the sort term. That being said the moves that we have seen have nothing to do with a market dislocation and there are no medium/long term reason for me to change my view about an allocation shift and investors being about to formulate a preference for equity market as their favourite asset class for the next few years.
This sudden investors twitchiness we probably can attribute to a combination of factors: Some degree of credit crunch engineered by the Chinese authorities to slow down speculators. The expectation of Bernanke ending the overly easy monetary policy conducted by the FOMC. The significant pull out of the bond markets triggering some risk aversion and funding need and therefore take profit on long equity positions to finance losses. Similarly a rebalancing of large funds since their bond/equity mix will have been affected by the fall in the bond valuations. I have to say however that overall I am at loss as of why this market reaction…clearly if the central bank are thinking about taking back some of the liquidity they supplied to the markets this means without any doubt that things are getting better out there. Also if one dissect Bernanke recent statement, he has made it quite clear that the FOMC decision will be driven by the economic data. So the ease of the monetary policy is there to stay with us for quite a while he is not about to hit the brakes but rather release pressure on the accelerator pedal as he put it. Anyhow in those times of market irrationality I like to look at some of my risk indicators described in: Is it Armageddon yet ?
The VIX seems to have remained close to its long term median, its own volatility was muted and my ShockIndex, a ratio of the VIX volatility divided by the VIX level 21 days earlier tell us that indeed we have seem some degree of upside acceleration in risk levels but nothing that can be classified as a market dislocation. Now the question is how long is that market jitteriness supposed to last ? In trying to answer that question I find it useful to use a 2 states Markov Regime Switching model using the VIX as an input. The MRS establishes a transitional probability matrix to give us an idea of which state we are in, its duration and likelihood to go into the other state. The results are shown below. The first chart shows that we have been in a “Risk off” state” since the close of the 7th of June. The model also tells us the typical duration of this Risk off regime should be about 11 days. Bearing in mind that we have already seen 10 market sessions in the “Risk off” state, more joyful time should come our way….
The second chart in the above panel shows the VIX and a forecast for the next day. Based on a close of 20.11 on the 24th we should expect the VIX to drop back by about 1.2 points during todays session…..which would be consistent with an up session in the S&P500…..
Follow up of “USDJPY Oversold ?” : Nothing like a bit of self gratification and a picture who is worth a thousand words……
Following my previous blog “Are Equity Markets Overbought ?” I am now looking at G10 FX using the same methodology. I have therefore adapted my script to download Daily FX rates from FRED. The Federal Reserve Economic Data is compiled by the Federal reserve bank of St Louis, a goldmine for you quants out there….Anyhow the results are here below.
My conclusion from the above charts is as follows: There are no currency in overbought/oversold territory anymore (G10 FX) . The only culprit was the Japanese Yen which had depreciated against the US Dollar well beyond normal statistical levels. However this has corrected sharply across the last few weeks with the yen appreciating close to 10% against the Greenback since May 21st. In fact the Japanese Yen is now significantly overbought against the US Dollar on both the 1 week and the 1 month time frame with T-Statistics of respectively – 1.99 and – 2.67 for those periods. Bearing in mind that the market may have been a bit too sanguine in its interpretation of how significantly and speedily the Fed will withdraw liquidity from the market it may well be that USDJPY is the odd one to look for prior tomorrow’s release of the FOMC minutes. If we are provided with any possible interpretation for a continued dovish policy via the FOMC statement , I would expect to see global equity markets to make some healthy ground and the current correlation between equity and Yen to resume…. USDJPY currently at 95.20 seems cheap to me…….
There has been some talks about the equity markets being overbought as an explanation to the recent bout of volatility, so I thought I would put the recent moves in perspective. For doing so I have written a small script in R that downloads the main stock market indices from the YahooFinance Website and then estimates the T-Statistics of their daily returns over various time windows, namely 1 week, 1,3 and 6 months. The T Statistic tells us if the move observed over a given period was “normal” or not. The critical threshold used in the analysis is 95% , i.e we can reject the null hypothesis 95% of the time assuming the underlying has a normal distribution. Clearly financial markets are not normal and there are limitations to such a test, however it is my experience that it gives an information which is probably more reliable than what you would get from an RSI or any other technical indicators. The results are visualized in what I call a “stretch map”. There is one section for each time period and the size of the squares are a function of the level of the T-Stat (the bigger the T-stat the bigger the square). The map is colour coded , red for downside, green for upside. It therefore provides an easy way to spot abnormalities.
The map reflects well the fact that markets have been somehow sold over the last month and most particularly the like of Canada, Brazil,Mexico and Hong Kong. So it seems that is is more an EM story than a G10 one. Also when we look at the 3-month Rolling T-Stats of the stock indices it seems that none are currently in an extended territory (oversold or overbought).
The Nikkei was the only one recently to venture in what I would define as an overbought territory but it since has retraced somehow whilst preserving most of the gains delivered since the beginning of the year as can be seen from the FT Macro Map that shows the 6-month performance of major stock indices.
6-month Performance of major stock markets as of 17/06/2013
On any account, stock markets seem to be currently in a range that would be expected under an assumption of normality. It may well be that they still present good value ahead of the next FOMC . Seems like the good days for equity markets are not yet over by any means…
It seems that recently we are having a media focus on the relationship between the Yen and the health of the Japanese stock market. Clearly in time of market volatility it is usual practice for analysts and alike to attempt to detect relationships and stick some explanatory variables on it. Someone has to make a living I guess…The current media contention is that the strength the Japanese Yen somehow explains the recent demises of the Japanese stock market. Clearly there may be some degree of truth in this as a stronger Yen would somehow dent the commercial margin of exporters and therefore some degree of correlation should be expected between domestic stock value and Yen (depending on the hedging approach of the underlying companies). That being said, a strong yen would also reduce the cost of importing goods and energy for Japan so overall the effect may be not as pronounced as one would expect. The below chart shows both the evolution of the Yen and the Nikkei since 1996 and the rolling correlation over a 125-day rolling window of daily returns. There has been a strong increase in the correlation but it still remains below the statistical threshold of significance….. What we observed is also somehow atypical of the whole period where the correlation remained muted and oscillating at levels close to Zero.
Rolling 125-day correlation between daily returns of the Nikkei and USD-JPY exchange rate.
Clearly the correlation test focuses on the similarities of the series deviations from their own means, so it does not tell us the story. If the Yen affects the margin of exporters/importers and subsequently the perceived valuation of their stocks, one would expect a causal relationship to be present. So it is clearly time to go quantitative on this. In the following we look at the 125-day rolling P-values of a Granger causality test .
125-day rolling P-value of Granger Causality test.
Looking at the above results the causal relationship has been instable. True, as of recent time the value of the Yen seems to drive (cause) the relationship but there has been periods in the past where the Yen has been significantly strong/weak and this had no effect on the way the causality works. In summary though there may be a bit of truth in a possible relationship it is clearly a weak one. To predict the Nikkei I would rather focus on other factors such as Domestic/Foreign appetite for Japanese assets in period of renewed economic growth…..
There is a smell of burning coming back to the financial markets. It seems that yet again the market has decided to focus its attention on the likelihood of the Fed tapering down the stimulus it provided. We are now all waiting for the dreaded NFP release again. But hold on a moment ! where is the logic behind all of this sudden short-termism embraced by market makers and speculators? Surely the FOMC has better and more real time access to economic data than we have ? if they decide to taper down it is likely that their view is that the economy is improving. Surely things are getting better, At 7.5% the US unemployment is at its lowest in the last 4 years and exporting companies have thrived on a weak dollar . True the last few days have been a bit incisive for any equity portfolio but overall the year to date performance remains excellent.
1-month performance of global equity markets
6-month performance of global equity markets
Personally I would not bet on one Non Farm Payroll data release influencing the FOMC decision one way or the other nor on them withdrawing all of the liquidity provided too quickly. The approach will be gradual. Of course there will be worries of the markets front running the exit and ensuing serious fall out in the bond markets but central bankers have been very resourceful at finding ways of controlling markets exuberances. It seems to me that all of this should not be a surprise as it has been already widely and openly debated. What we observing is rather more likely to be a case of the market going in summer mode to take a few Bulls out for a ride. In those moment of frenzy I like to look at some quantitative risk classifiers rather than focussing on the flurry of headlines of journalist and analysts who are paid by the line. The level of implied volatility in the equity market as express by the VIX, sometime labelled the fear Index is a good start but it does not give us the full picture. I tend to prefer to look at the volatility of the VIX itself as a measure of (un)stability of the perception of risk (I.e how volatile and unpredictable the risk itself has become). Finally the ratio of the two (VIX Volga / VIX) which I label the shock index is also a good measure as it expresses how quickly the risk has become unstable over a window of 21-day. The chart below shows these measures and also frame them within their historical distribution.
So far it does not seem that the market is behaving in a dislocated way…..I ll hang on those long equity positions for a while then…
I have been extremely fond of a bullish equity market scenario since early 2012. This play has now worked well despite talks of dislocation in Europe , Korea bellicosity, possible slowdown in China and other potential risk events. One of the triggers behind my view was an early realisation that the extremely loose monetary policy conducted by central banks would feed into an unsustainable bubble in the bond market and that this would activate a logical shift in both the private a public asset allocation preference.
Clearly, so far, central banks have been successful in bringing nominal and real rates to unprecedented levels and by the by have incentivised market agents to seek assets with higher returns and also higher intrinsic risks. Furthermore any upside in inflation will bring real rates even further in negative territory and bring another incentive for private and institutional investors to channel their capital resources toward riskier assets. This may prove a useful re-allocation of capital though it will create issues for central bank when the brunt of the shift take place as bond valuation may undesirably tumble. Meanwhile I would argue that despite the significant move we observed in equities over the last year , we have not yet seen the full delivered effect of this ultra-loose policy stance.
World stock markets 2012
S&P 500 2008 to date
Investors response has been muted and we have not as of yet seen a significant asset allocation shift toward equities. This is well demonstrated by the data on US Mutual funds in flows compiled by the Investment Company Institute in the US. During the first quarter of this year we have started to see the premise of a what could become a significant move as private and institutional investors have become less sticky to their cash holdings and allocated some of their capital toward equities. However bond holdings remain at a level that statistically is highly non-normal.
Bearing in mind the low yield of the asset class, bettering growth in the US and public debate about the Fed exit policy, it becomes more and more difficult to ignore the bond bubble engineered by central banks. Also the attraction of greater excess returns that have been side-lined by most investors because of black swan and a “al la Roubini” doomsday scenarios becomes more tempting…. What may explain part of the move in stock markets so far is that companies are now more efficient due to their cutting costs ahead of expected difficult times. Therefore their stocks have been re-priced to reflect their stronger balance sheet and reduced borrowings. The price adjustment has not been led by a change in the investor inventory so far but by a new perception of their true fundamentals. The massive capital destruction that took place in 2008 conditioned investors, analysts and media to adopt a risk averse stance. Their financially induced behaviour remains proportionally sticky to the amount of pain endured and to some degree has been self feeding as reflected in past numbers of consumer confidence. Consequently the appetite for risk remains low for a long time due to the intensity of the capital erosion we experienced. The 2008 financial crisis created a self feeding mechanism where pessimism and formulation/expectations of doomsday scenario would become the rewarded norm. Economists became suspiciously short term in their views due to economic data becoming more volatile and therefore more difficult to forecast. Analysts and journalists got better rewarded for being a “Roubini” rather than isolated optimists. This change in behaviour has not delivered value to the end investor. Scaremongering drove investors to become sticky to their riskless assets and to ignore substantial excess returns that capital markets had in offer for them. Potential liabilities and fiscality risks drive institutional and private investors to reconsider their allocation of capital. In the one hand it would be reckless for pension funds not to reduce their bond exposures when the Fed start to debate their exit policy. Rising interest rate as central banks will withdaw liquidity potentially create significant short/medium term liabilities on their bond portfolios potentially inducing significant portfolio re-balancement. On the other hand rising fiscality by government seeking to replenish their coffers will drives private investors to demand higher returns. They will achieve this by investing in riskier assets and by going cross border to chase higher opportunities. My thought is that as the preference shift for stocks will take place we will see companies put this capital to work to capture new market opportunities and further invest into R&D. Exactly what governments and central banks want since it should generate new jobs. We are about to enter a long cycle where equities will dominate as the investors preferred asset class. As more cross-border investments will occur we will see stronger trend and higher volatility in currency markets which have been lacklustre over that last few years. I would expect the US Dollar to remain weak as much private capital in the US will seek diversifying opportunities… I ll stay long equities and definitively away from bonds for a good decade…