Feb

22

Do markets learn from each other?  For example, is the S&P market this year following a similar path to bonds last year, with every trepidatious move down being requited with a rise? Are such "learnings" graduated to the point of regularities. And is it a domino effect or a path of least resistance or consilience or convergent evolution or what have you? What do you think?  Can it be quantified? Should it be quantified?

Allen Gillespie answers:

Yes they do.  In the old days that could be because some pits closed before other pits, so you could have individuals walk between pits and trade both.  Today it would be the result of correlation trading desk and carry trades.  The correlations, however, do change depending on what the Street owns - it is simply a balance sheet effect. There is also the issue of relative levels v. absolute levels.  This is important because leveraged and professional traders may act on relative relationships more quickly and at higher price levels, where as, unleveraged traders need both an attractive relative and absolute relationships to act.  This is the problem with ZIRP.  Discount models become meaningless near zero i.r. as values become highly sensitive to small changes and price changes gain increasing amplitude.  It encourages leveraged carry trades regardless of the absolute levels sought by cash buyers. That's the issue now no? Inflation targeting is just the gold standard, and under the gold standard short term interest rates were highly volatile while long term ones were not because there was no long term inflation except for natural growth which caused periodic revaluations of the currency. So, the Fed views long bonds as the same as cash, however, this is because the Chairman does not believe that currency is supposed to serve the function of acting as a store of value.  If it cannot serve that function then it truly is worthless.  

So, stocks are following bonds because there's 600 bps of carry (relative to the Ten Year last August) or 800 bps of carry (relative to ZIRP) or 500 bps relative to corporates.  I call it the old bankers trade (3-6-3), borrow at 3, lend at 6, play golf at 3. Stocks then would give you an additional 280 bps on the 6. The issue now is 0,3,6 (borrow at 0, lend at three, get up at 6 because at $1360 on the S&P the earnings yield is 6.4 and this probably does not adequately reward investors in a world where the currency is worthless and where the value of a $1 perpetuity at 10 bps is $1000 and at 11 bps $909 and at a mere 15 bps back to the deal with the devil $666 that the S&P made in 2009.  Another way to consider it is to think you will get that 6.4 two thirds of the time or 4.25% which is still better than a bond, but is it adequate?  AA bonds have a 20 year cumulative default probability of 2.71% but an average loss severity of 36.5% or so at anything less than 2.3% they really have used your money for free for 20 years.  Didn't our president say something about spreading the wealth around? Well, using money for free would meet my definition of how to do it.  So, we are in the ABT market (anything but treasuries) since last August and I truly suspect current bond issues will someday be referred to as those Obamanations like the old not worth a Continental all made possible by Wall Street's deal with the devil at Fed.  The rub is the math works both ways.  

One way to quantify would be to take all market periods (say one year) and then run a correlation against the second market 1 year forward, with the hypothesis being that would be see consistently high correlation numbers.  Thus one would see not just the direction of the relationship but the consistency.


Comments

Name

Email

Website

Speak your mind

Archives

Resources & Links

Search