Thursday, May 23, 2013

Face-off with Risk - Stock and Bond markets respond

After a decade of trading equities, options and futures, I could recognize yesterday's morning reversal as something important. Today, we face further downdraft as market participants adjust their risk profile to the level where they will be comfortable next Tuesday, when markets reopen after the holiday weekend.
illustration of a May Calendar crossed over
Sell in May and go away
Next, we face the issue of seasonality. The whole sell in May and go away is real. Much of Wall Street takes longer vacation breaks during the summer. As a result, liquidity drops and intraday volatility increases. In general, except for something big unexpectedly happening, money managers are not willing to add money to rising positions during the summer. Valuation growth usually waits for a few months.
I am sure that you have experienced a time when your company grew nonstop. The feeling among your team was that momentum would carry sales higher, but instead sales dropped. Why? It was simply that all possible buyers of your products made purchases during the momentum buildup until there was no one else to buy. In market terms this is referred to as a lack of marginal buyers. With not one additional willing buyer, sales abruptly stop and momentum turns negative instead.
As I saw the futures go negative in real time during Bernanke's speech yesterday, it looked as if marginal buyers were pushing for the last time. An absence of sellers gave the last buyers the chance to quickly drive prices very high. Then a flood of new sellers came in; overwhelming buyers. At the end of the day, the large reversal and the massive volume confirmed suspicions that the market was ready to exit risk.
It is important to understand that US equities have been rising due to a lack of good alternatives. It is not abnormal for money managers to drink their own Kool-Aid and wax poetic about the great logic behind their purchases of ballooning assets. I saw this exact same phenomenon during the last recession. Despite seeing construction spending collapse after April, 2006, buyers of real estate assets continued to binge for over a year more.
We now need to keep an eye on the end of the month. If the S&P 500 ends the month around 1,600 or lower, be ready for the fall to continue.
image of US Treasury bonds
Treasury Bonds
For bonds, on the other hand, things are not so simple any more. Summer is usually the time when bonds go up in price. This time, though, there are doubts looming over the historic bubble that, after thirty years, is now finally ending. When bonds start to move, they will drop in value so much faster than equities that your head will spin. Incredibly, bond assets that are usually associated with safety now carry disproportionate risk
As long as our political leaders continue to promote ideas of wealth confiscation, or as Obama calls it wealth redistribution, market risk will not change. Businesses everywhere will continue to refuse to make long term investments.
image of a Nobel Prize medal
Nobel Prize
There are a few economists who believe that people do not actually think rationally about what they do. As a result, they assume that businesses do not respond to risk with the same predictability as perfectly rational players. To them, I offer that large companies do in fact plan based of sound risk assessments. Medium and small companies, those lacking the expertise to process such information, depend instead on banks to determine when the right time to make investments is. Yes, the bond vigilantes are back. Everybody knows that the bond market is much smarter than the equities market. Bond holders are lenders; bankers are lenders; there must be something in the water they both drink. As market risk increases, bankers increase borrowing hurtles. This serves as an effective mechanism that forces small and medium businesses to operate as if they too were perfectly rational about risk. There you have it, cake all over the face of those Nobel winning economists. They should get out more often.
If we want to see a better economic future, a new era when markets reflect real values and not distortions created by governments, we need to stop allowing our leaders to continue to make business the bad guy of the movie.

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