Recap 10-18-12: The Tactical Outlook

Commentary:

The 9/12 forecast for a short term high in risk assets has broadly played out. While the medium term trend remains higher for risk assets, there may be a decent chance for a further small correction in the next few weeks. The rationale is based on the following:

  1. Weak Earnings. We’ve had a second quarter of weak earnings, where the number of misses vs beats exceeded the long term average. Historically, this has driven mid single digit corrections within the quarter.
  2. Defensive Rotation. Since the Sept 14 high, the S&P is only down slightly, but this masks substantial defensive rotation. The below shows the change of various sectors over the same period. Note that almost all cyclical sectors are in the red, while almost all defensive sectors are in the green:

  3. Skew. The options market is also pricing in an increasing amount of premium for puts versus calls, which is also historically consistent with short term corrections
  4. Higher rates. Current coupon mortgage rates are now HIGHER vs FOMC levels, and over 50bps higher above the lows. While that doesn’t mean mortgage credit will be tightening, it does suggest that the anticipated surge in housing purchases & mortgage refinances may not match expectations:

  5. The US Election. Online betting venues places the odds of an Obama win at roughly 2:1, and similar odds for the Democrats to retain a working majority in the Senate. There are actually a number of similarities between this election and the 2004 election, the details of analyzed at the end of this message. The key idea is that such an outcome would be seen by both parties as a popular mandate for the Democrat’s fiscal plan, which predominantly targets high income and capital gains as sources of revenue. Such an outcome, when compared with the consensus expectation that the election is a toss-up, is likely to introduce short term downside risks for stocks. And if we use 2004 as a guide, the effects may be focused on the weeks around Election Day.

So in aggregate, there may be merit for staying defensive for a while longer. A break above 1475 would substantially reduce confidence in this view. Remember, however, that due to option expiry, we are not likely to see a move this week.

Notable:

  • US Jobless Claims jumped 46k last week to 388k vs 365k exp, 339k prev and 369k before that. The 4wk avg increased marginally, but sits just above the lows.
  • US Philly Fed improved to 5.7 in Oct vs 1.0 exp and -1.9 prev
  • UK Retail Sales improved to 2.5% YoY vs 2.1% exp and 2.7% prev
  • FT Alphaville notes that almost new housing units are all rent based:

  • China Sept Data:
  1. 3Q GDP rose 2.2% vs 2.0% exp and 1.8% prev
  2. IP rose 9.2% YoY vs 9.0% exp and 8.9% prev
  3. Retail Sales rose 14.2% YoY vs 13.2% exp and prev
  4. Fixed Asset investment increased to 20.5% vs 20.2% exp and prev

Upcoming Data:

  • Fri: Option Expiry, Canada CPI, US Existing Home Sales
  • Mon: Japan Trade Bal
  • Tues: BoC, Canada Retail Sales, AU CPI
  • Wed: EU PMI, German IFO, USMarkit PMI, US New Home Sales, FOMC
  • Thu: US DGO, Jobless Claims, Pending Home Sales,

Comparison of this election vs 2004:

Like the case this year, the 2004 election was fairly close from a popular vote perspective. The percentages were 50.7% vs 48.3%, a spread of just 2.4%. Kerry was the underdog going into the 1st debate, but consensus conclusions were that he won it decisively. Going into the final week, polls had the candidates roughly neck and neck. However, support for Bush jumped dramatically following the release of a new bin Laden videotape claiming responsibility for the 9/11 attacks and taunting Bush. Also close was the Senate outcome, which was split 51:49 in favor of the Republicans.

Somewhat at risk in 2004 were the Bush tax cuts. The 2003 cuts were voted on almost completely based on partisan lines, and there was some uncertainty regarding whether they would continue. The jump in Bush’s poll ratings going into Election Day coincided with a sharp rally in the S&P (yellow, below) although this should be taken with a grain of salt because it coincided with a sharp improvement in the data. (Economic Surprise index in white)

So in conclusion, there may be a mirrored, negative effect this year, although the OK data suggests the effect will probably not be large.

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2 thoughts on “Recap 10-18-12: The Tactical Outlook

  1. If any of the major dealers’ eq derivs desks take you out, they’ll tell you that 20% of the volumes are now in weekly and short dated options, largely macro funds, punting given low implieds. Even variable annuity types have been buying their protection in shorter dates, 3m, 6m. And tail risk funds are “said” to be absent the back …. Why this steep vol curve persists is a puzzle, though nothing is realizing. Gold vol similarly steep and cheap in front.

    China/aus stocks, iron ore, freight futures, even aud tracking upwards. ABS/Structured credit hfs killing it. BRL still pseudo-pegged. High yield vol perhaps a good, if pricey, risk-off hedge.

    Lastly, bizarre action in many mReits … Hearing mtg repo jumped 10 bps in one day and many are reluctant to hold tight-spread paper into yr end but no real answer … Lot of money chasing yields: em bonds relentless etc

    JPM has a note where they recommend a basket of buying past losers, selling past winners into December as part of an Obama-wins mean-reversion tax-related trade

    –No pictures in your post came through

    1. Thanks for sharing your thoughts!

      I guess this is an off shoot of a world where asset prices seem disconnected with economic data – Low conviction, short term punts. I know I haven’t done much in a while. Vol rolldown trades have worked well for some time – harder to make money without taking gamma risk now. I closed out of my short vol positions recently.

      You’re right, carry is the name of the game. Feels like the party can go on for a while, though. mReits … think this will wind up being a buying opportunity. Prepay rates have certainly increased, but they’re not gapping higher like in previous mReit scare episodes. As the change is somewhat gradual, I think most of them will be able to manage OK. And current coupon rates are now higher vs FOMC levels. We’ll see at the end of the month.

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