Ok a lot of analysts are calling for lower oil prices, possibly to pre-2000 levels….does it mean that we are close to the bottom …or possibly that have missed it ?
Whatever the market being traded, there always will be a a question being asked at one moment: How far can this thing go ? Clearly not an easy question to answer as this will invariably depends on factors that are partly unknown or difficult to estimate, such as fundamentals, market positioning or market risk amongst others. The first part is obviously to assess how atypical the move experienced in the given instrument is. This report aims to contribute to this. The below chart shows the Reference Price for the OPEC Crude Oil Basket over the period of January 2003 to February 2015 . at Close of business 16 February 2015 it was trading at 56.43. In the below I used an R script written by The Sytematic Investor to plot the previous 250 days against other similar historical periods that would have closely matched the recent history. The data has been normalised so as to be on the same scale. The chart shows the latest 250 days in black, and overlay similar historical patterns in grey. It Also shows what has been the price path for the following 250 days as well as the observed quartiles. Finally I plot the last 250 days and a trend forecast derived from an ARIMA(1,1,0) model as well as the 95% confidence intervals. The ARIMA model is fitted to the past 750 historical values whilst ignoring the last 250 days, therefore we can look at the recent price path against the trend forecast and its confidence intervals to gauge how (a)typical the recent move has been.
Ok we have had our fair share of event risk so far this year. Ukraine, Israel, Portugal to name but a few….and we now have Yellen telling us that the Fed may hike the rates earlier than forecast. And guess what ? The Vix is still trading in the low bottom quartile.
Though my shock Index (ratio of VIX volga and Vix over 21 days) did venture above its long term median value on the back of the Portugal news, all of my risk indicators remain well entrenched in risk seeking territory….
My 2-state Markov model continue to sell volatility…I am not sure I would but I can t fault the outcome of the model so far.
Bearing in mind the above I am still a bit quizzical as of why risk is trading so low. We are getting indeed very little reaction from events that once would have sent the VIX flying into the 20 to 25% range . The only rationale I have is that Investors are now accepting that growth is significantly taking hold and therefore investment flows are logically channelling into risky assets and carry trades. Also there is now a strong understanding that central banks are determined in doing whatever is necessary to support growth and rid of systemic risk. This clearly has a strong dampening effect on any risk spikes, but lets not get too complacent about it…
The latest batch of US mutual funds inflow/outflow data has been released by the Investment Company Institute in the US today and guess what ? It is business as usual for US investors….Buy international equities and sell bonds…guess no one has been paying scant attention to the equity market wobbles we have seen aside the wannabe Roubini and other scaremongers of this world. anyhow the usual charts are below….
No doubt the international equities buying trend remain strong and this despite the recent comments by Yellen and weaker than expected ( but not weak) US economic data as well as the recent jitters in the equity and emerging markets. Clearly this may have provided a short term respite for bond holders but my thoughts are that all this will be short lived and that we will soon see the 10-year US trading above 3%. Also the continual purchase of international securities by US investor is likely to bring headwind for the US$. This is possibly highlighted by the high resilience of the EUR-USD bearing in mind the differences in yield and economic growth of both the US and Europe…..Bearing in mind the rumoured long US$ position of the market it may be tempting to become contrarian. Even at 1.3600 the Euro could still provide some good profit opportunities…..
Another batch of data has came out from the Investment Company Institute and though for the first time in a long time we are seeing modest inflows into taxable bonds funds, the theme is still about buying International equities for US investors. as the below charts indicate (click on them if you want to see larger versions).
The appetite for equities clearly affects market risk and as can be seen through our Markov regime switching analysis the market is still in risk on mode.
The world appetite for risk and returns seems to pick up and economies are doing better (even Europe does…). So if the Chinese GDP does not come much worse than expected or surprise us on the upside it could be an interesting few weeks ahead for us Equity Bulls…..If it is worse I guess it will provide laggard with a better level to enter the market.
Seems like the markets have rallied top the idea that the budget ceiling limit is sorted out…so it is business as usual…buy equities ! and probably a little bit of dollar as the relief trigger some short term enthusiasm….but you know my view on that one. The ICI US mutual fund flow data definitely point out to some significant flows going into international equities, so the dollar weakness will come back….Anyhow I re-run my Regime Switching Markov model and there is definitely statistical agreement….Risk On sell the VIX !
Ok what is happening in the not so great US of A ? Markets were clearly coming to a lull and Capitol hill has decided to spoil the party by throwing us a curve ball with this on-going wrangling over the budget and debt extension ceiling. Can you imagine the US going into default ? No one has any real idea of the full impact of such an event and because of this we see the Roubini of this world crawling out of the woodworks. Even Buffet mention the event has being potentially “Nuclear”. Clearly the US has already partially defaulted in 1979 on some of its treasury bills, this moved the yields by about 60bps in one day which by European standards does not seem much. Anyhow Forbes has published a good column on this…So this time is it different ? Well from what we can observe in the equity markets the reaction has been somehow muted. We have seen some retracement over the last five days but it still leaves us with a very healthy performance since the beginning of the year (assuming you invested globally in equities).
Fig. 1: 5-day return of Stock Markets Fig. 2: 9-month return of stocks markets
Bearing in mind the nearing of the 17th of October which is when the US could potentially find themselves in default if the extension of the debt ceiling is not agreed upon I thought I would look at my risk indicators. The left hand chart shows that the VIX is still trading near its long term median, that the volatility of the VIX (Volga) is also close its median and that the ratio of the Volga and the VIX which is a good indicator of financial system shocks has remained close to its median also. In other words by these metrics we are still in a happy, long risk world.
However the chart on the right hand side shows the probabilities of being in a high risk or a low risk environment derived from a 2-state Markov regime switching model applied to the VIX. In simple terms the Markov model aims to split the sample under review into two distributions (low risk, high risk) and to establish the probability of moving from of distribution to another. Clearly it seems that something has changed (in fact it started to change on the 29th of September). The model does seem to indicate that a bit of caution may be a good idea……Let ‘s hope those guys on Capitol Hill get to some convincing agreement …..I ll keep my tin hat at close range, just in case….