Recap major market points - Equity Bond, Variance Swap Levels, Portfolio performance and the upcoming year end rally?

Recap major market points - Equity Bond, Variance Swap Levels, Portfolio performance and the upcoming year end rally?


Equity Bond - Set it and forget it.

PFG is setting up the  SPY Dec 2013 (2.2y maturity) 75/90 Call Spread.  This trade will pay ~15% pa if the market is above 900 and we break even at 860 on maturity.  With the tax treatment better for long term capital gains vs interest payments, we find that taking large cap diversified risk with such a high “implied coupon” over a high yield corporate is a far superior trade.  The only reason this exists is due to high volatility/correlation, which we believe will come down.  The key to this trade will be to enter on sell offs.  The four week graph is below.

Another way to think about this is that you are paying 73% for today’s market level, 2.2years forward.



Variance Swaps - Continue to be stubborn, why?  CHINA

As we can see below, the graph speaks for itself, the market continues to price in fear into all parts of the curve, globally.



Portfolio Performance - flat weekly return

We have not got the instant payoff as on our other short term vol bets, however PFG continues to believe in the thesis and will continue to hold the short strangle.



Year End Rally?

In spite of what seems to be extremely wobbly market for us folks who watch it everyday, the market is practically in the same spot since the start of August.  Since then, the Euro Sov story has been recycled about a few dozen times daily and the US data, which is still bad, stopped getting worse. The economy is being reflected well by the global stock markets, we are simply bumping around till better clarity is found.  However, during this time, the market has faced redemption's and PM’s are reporting increasing large cash holdings and EM funds have had pure outflow (see graph)


So then the large question is what if we enter risk - on?  A large pile of cash will need to find a home quickly, especially if PM’s are going to be marked to year-end?  Are we setting up for a major stock market rally?  Simply put, this market is transferring solid assets from the weak hands to the strong as we shift through the de-levering process.

How to take advantage of the high back end in vol? - Turn it into a bond that pays 20%

How to take advantage of the high back end in vol? - Turn it into a bond that pays 20%

Using the SPY options table below, we can see the different combinations of call spreads and the “coupon” (via capital growth pa) they will return if the market stays above the upper strike.  This is an excellent way to use the current high vol in the market to create a bond type return.  

• 3M SECTOR CORRELATION IS @ .94.  10Y AVG = .67  20Y AVG = .58
• RETURNS CORRELATION IS    @ .75    10Y AVG = .49

This market has plenty of edge in it, that is clear from any metric.  However, what is going to guarantee fresh selling of long term vol?  Our thesis and metrics are only parts of the puzzle for this trade to align, we also need to have the “need” for long dated vol in the market to be absolved, the supply/demand dynamics currently don’t line up well for being short long dated variance swaps.  However, PFG believes that using near term vol (1y-2y) and trading in bond format provides an excellent return for a respectable level of risk.

Trade Idea - Sell short dated options - Why?

Trade Idea - Sell short dated options - Why?

It has become increasing apparent the vol market is positioned the same way as the fed, they have sold long dated vol and bought short dated options - i.e. long gamma, short vega.  This also helps explain why the long end has been so stubborn in coming down, the street is short to clients or via correlation/dispersion books and are patiently waiting to cover with no luck.

On Friday, we noticed a very interesting observation in the market, “market up, vol up”, this typically means that traders want to have either a flat gamma or long gamma book to catch a catalyst or defend a short vega position.  This in turn will have overwhelmed market makers and they kept short dated vol high in spite of the market calming down and moving higher.  This tide will turn quickly with in two states

1. Somewhat calm markets (small rally)
2. Positive News on the margin

As soon as the decay (theta) in the books of option traders starts to overwhelm the position with no lowering of the vol in the long end to help, the front end of the vol curve will quickly get sold as the bleeding of options becomes unmanageable.  The curve will steepen fast.

TRADE IDEA : SELL SPY DEC 95/130 STRANGLES @ 3.50$

Almost every 12M Variance Swap hit a 52W high

To understand the scale of forward fear in the market, one has to only look at the global 12 variance swap levels.  Almost all, except Japan and Korea hit 52week highs.

As noted in our closing trade post, on the margin, a need exists for vol and has spilled over into curve.  This clearly is setting up for a great vol shorting opportunity, as these levels have not been seen since the 2008 financial crisis.  However, we are not convinced this is the right moment.  We are going to wait to sell on the way down.  The edge in the trade is clear.

Global Variance Swap Snapshot

The largest changes in 12m variance continue to be in Europe.  Investors have also started to worry about China, as we see large moves in HSI since last week.  Asia- ex China continues to be very quiet.

Twist Translation = Fed buying short term vol, selling long term vol

Twist Translation = Fed buying short term vol, selling long term vol

A comment commonly heard from the market is “don’t fight the fed.”  PFG plans not too, but we will join them in using this event to sell long term volatility.  This “twist” function, Japan playbook or whatever it is being called is yet another support for decreasing long term volatility and keep the stock market bumping around the lows with no real legs as the financials/government/individuals are stuck in the “asset leverage trap.”

Trade Closed - One week return +36%

Today we got one of the best exit points, with both market down and vol down.  This is usually a great place to exit as long vol players got the QE3 event and the need for vol is no longer.  This on the margin leaves the market a net buyer of short term vol.  Working on next trade.

What about Greece? What about it? - Corporates support lower longer volatility

What about Greece?  What about it? - Corporates support lower longer volatility
Two of the largest challenges now facing the world are Euro Sov and a large US slowdown.  However, on the flip side, we have corporates with the highest cash levels in 25 years.  In fact, they also have the best debt, interest and EBIT coverage on record.  For any long vol trade to payoff exponentially, you need the market to “break” violently. This is hardly possible under a non-euro zone default.  Corporates have de-levered and are benefiting from lower borrowing costs.

Let’s examine each scenario

1. Greece “ I don’t want to pay”  

I don’t think anyone has edge in this situation, the spillover would be hard to contain and we could see large pensions wiped out and rampant speculation on who is next.  Can we put a probability on this event happening?  PFG would put it close to zero.  

The FT has a great “what if” below.  If the situation does occur, the world could easily say “I told you so” but I doubt we see a yawn, the global market in spite of being prepared for bankruptcy, would get rattled.








2. US  Slowdown

Very real and PFG believes once the dust settles from Europe, the US jobs situation, the upcoming 2012 election will be the dominant stories moving the markets.  The battle will continue of US Economics vs Corporate balance sheet health.  PFG believes this will produce stale markets for a very long period, again supporting the case for lower long term volatility


In a picture






What could go wrong?  CHINA.  PFG believes that once the spotlight moves from Europe, it will start to shine on China and amplify many of the problems we see today.  From being the global counter-party, lender and growth leader, China may have too much on it’s plate and a small reversal could send the global economy screaming for cover.

Global Variance Swap Snapshot

The above graph shows the 12 month variance swap levels for global indices. Small cap and Euro zone stand out while UK and Japan are below the avg and Asia just kissing the average levels.  This is hardly to meaningful, since its always best to measure each asset on its own vs realized, but we can clearly see very elevated levels globally.  In fact, each of these levels are about 7-15 points above the localized average of each index, implying a 12 point possible edge on a global average.

At the close - weekly performance +16%

Currently, we only have one trade to express our short vol theme, short SPY Nov 100/130 Strangle.  


TRADE IDEA : SELL SPY NOV 100/130 STRANGLE @ 3.30$




CLOSING LEVEL 2.85$


We continue to favor this trade and will add more at 3.15$ or above.

PFG

Looking at the yield spectrum - Best of both pays 6.85% + Capital Gain resulting from global yield hunt (i.e. lower long term volatility)

Looking at the yield spectrum - Best of both pays 6.85% + Capital Gain resulting from global yield hunt (i.e. lower long term volatility)

When looking for the best of both worlds, stock risk and yield, we usually turn to the convertible bond.  Decomposing it we have three parts

i = bonds
r = credit spreads
v = vol

Parts	Cheap	Rich
i		X
r		X
v		X

This decompostion tells us that today’s zero coupon bond is very rich, thus leaving very little money to buy vol (a call option) which in turn is very rich itself.  Not a very interesting sum of the parts to get the best of both worlds.  However, we do have the option then to look at different bonds and slide higher up the risk scale spectrum to find a cheaper, however riskier bond that can also provide a chance for capital gain. Below is graph of assets vs yield (avg etf in sector)

If we separate the above graph in half down the middle - 1. Government Safety and 2 . Corporates, we clearly see that muni bonds and HY bonds are providing the best yield returns in the respective yields spectrum's.  REITs are the worst risk adjusted.

A combination of the two best, gives us today a yield of 6.85% and the possibility to capture credit spread/vol compression (via a capital gain in HY bonds).  This is far better then buying muni + call, instead, we are collecting the daily theta by taking the risk on HY bonds in hopes of a credit/vol compression - i.e lower long term volatility

The leverage asset trap - A case for lower long term volatility

The leverage asset trap - A case for lower long term volatility

As banks de-levered (mortgages and jobs) into the books of the governments and workers, we now sit with individuals being forced to de-lever personal balance sheets.  So has the world really de-levered or simply moving it around and each person in the chain taking a small write down till it finally overtime reaches it's fair value slightly north of zero?  If so, this process will take years and in the meantime we can expect a bumpy ride, however with each transfer resulting in a lower volatility regime as we saw in the japan debt fallout and that similar to 2004-2007 us pre credit bubble build. Except this time, stocks stay cheap, raw materials stay expensive and bid, interest rates force high yield spreads to compress and a constant currency battle aimed at pushing exports.

Currently this cycle is at the final step before being pushed back up to government.  A new global political debate arises daily on exactly who is left holding the leverage asset balance sheet.  However, impatient bond holders have driven values of the debt to 0, leaving global haircuts on bonds non-negotiable and frantic markets.  Governments now will be forced to hit private holders, sue banks, pull cash from corporates to reach political goals, avoid defaults, create jobs all in the name of "saving our children's future".  No mass scale default will happen.


With so much money moving back and forth along with blame, how do we even begin to come up with a long term fair value for financial assets - FX, Commodity Prices, Interest Rates, Volatility and stocks?

First let’s start with what the market is telling us about the long term in each asset using g= growth, r = recession, tr = trade result

Asset	g	r	tr
Stocks		X	Stocks stay cheap
Rates		X	Global yield hunt
Commodity	X		Buy to fund growth
FX		X	Sell USD to fund growth
Vol		X	Lower

Stocks are cheap, but will probably stay cheap for sometime until record cash rich corporations decide to part with it.  The raw materials for growth are very expensive while the human capital costs are very cheap.  Until a balance is found, corporations will only slowly invest into R&D, technology and hiring.  Only commodity linked companies will benefit from operating leverage EPS, while others engage in price wars for the shrinking spending of de-levering consumers.  In the meantime, the vol of cash is ZERO and that should get priced into the vol market.


Interest rates are clearly following the Japan playbook which in turn will bring on global yield hunt that will unfortunately not spill into equities until the market again gets to very tight credit spreads.  Vol compression and credit spread compression are highly correlated

Commodity prices are expensive.  Growth tools are simply not available for cheap as is human labour.  This leaves the market with higher bars and hurdles.  Until clarity is found on profitability for corporates to invest, expect commodity prices to stay expensive with a fairly stick bid.  A commodity collapse would only bring on more acquisitions as the cost of growth decreases




FX.  The world is hiding in the what is being perceived to be the safest countries, however the printing presses and export pain will only be tolerated for so long.  Expect a large USD squeeze followed by an even greater USD sell-off.  This will shake out many weak USD borrowers while allowing strong corporations to increase short USD positions to take advantage of cheap funding.  If you can’t hide in USD or EUR, then Yuan gets bid, strong Yuan buys commodity - large M&A, bigger firms, bigger market cap, lower vol

Vol  Already pricing in extreme daily moves relative to history, vol is clearly pricing in a bumpy ride for all assets classes.  This is rightfully so, as we now are approaching a possible risk reward snap back. How much reward is in buying vol for a tail event if we are starting from a near assumed default position?

Is all the bad news out?

Owners of Greek bonds at this point should know what they own, I can't imagine any Euro Sov debt holder to be hit with "shock and awe" every time negative news hits the tape.

One of the hardest trading environments is when the market continues to recycle the same news, yet the sensitivity levels to the news stay the same and the market continues to act as if it fresh and acts with knee jerk responses.  We are currently in one of these environments.  So the question for the markets is simply when do you stop to trade the same old headlines and focus back on fundamentals of companies? The market needs a new crisis to focus on- Going east, we move from the US Credit Bubble, Euro Sov, next stop we will land in China.  The market can never focus on more than one issue at the same time.

Greek bonds are currently priced at 90%+ default?  Look at the market response - zippo!  It seems the market deep down still believes that somehow, someway, the Greek challenge will get resolved and are happy to see to financials down as satisfaction.

Unless the market gets pushed over the line with a true unacceptable situation of no choice besides jumping into the abyss, PFG continues to favor shorting vol while the world decides what to do with the Greeks.  The pain of 50%+ drops in many Global financials stocks is satisfactory for us.  However, it is still very unsettling that the CEO's of financials continue to lie about Capital raises (BAC, Soc Gen).

What is a vol trader to do?  What is my edge in going short vol?  Headlines for September are packed with upcoming news about the Euro nations next moves, we believe at this point the market is prepared and the news is out.  Therefore, the need for new, marginal vol at these levels is no longer desired.

TRADE IDEA

Short SPY Nov 100/130 Strangle @ 3.30 - legging into trade, 4 tranches of 25%

Closing Trade for 25% 2week return - Thesis intact, however Sept events could prove for a market meltdown

PFG closed the short vol, short market thesis leveraged trade today at the close. The total return on the trade was 25% over two weeks.  In spite of feeling secure in our thesis, this trade no longer feels fresh and has caught the short term wave of two weeks of flat market action.  A better entry point will present itself in September.




Sept 9th


$ES_F = 1158.25
$GC_F = 1855.40
SPY Oct 100/125 Strangle = 2.86


Near Term Market Outlook


The market needs jobs, corporates are cash rich.  Until these two are fused at the hip, it will be very hard for the market to produce an extended rally.  Currently, weak or strong economic news is not helping financial stocks, and PFG believes this sector has no near term catalyst.  This outcome leaves the market starting from a position of weakness that needs real solid news/data to get some legs.


As with any push/pull market (jobs vs economic data), the end result is a grind, rather then a gap.  Thus, we still feel short vol, short market is still the best thesis to apply to this market, however it is becoming a little tricky to find the right tool to get the sharpest leveraged trade without getting involved in the cross currents of gold, rates and financials.  Better to wait for now.

Portfolio Update - 1 week performance 32.75%

PFGs short vol, short market thesis performed excellent this week, as vol faded lower, gold benefited from the sell off and the market had a flat week.  On the other hand, the high yield side of the same bet, really did not do much( -2.2%) as long dated yields collapsed and the bond market did not except a future calm path for equities.


Since the prime benefit was from gold and vol on this trade, PFG will continue to keep this position open as the overall path dependent lower grind is still intact.


Our index was up 23% and our leveraged implementation performed 32.77%


8/25/2011  3.728
9/3/2011    4.583


TRADE IDEA:


AUG 25TH
SHORT $ES_F 1163 SEPT
SHORT SPY OCT 100/125 STRANGLE FOR $3.60 CREDIT
LONG $GC_F 1774 SEPT


SEP 3
SHORT $ES_F 1169.30 SEPT

SHORT SPY OCT 100/125 STRANGLE FOR $2.62 CREDIT

LONG $GC_F 1881.60 SEPT

Trade Thesis
Date gld/vix vix gld spx b/e spx/gld spy/100 (gld/vix) /(spy/100) return
8/25/2011 4.33501006036217 39.76 172.36 116.28 26.8234671617545 0.67463448595962 1.1628 3.72807882728085
9/3/2011 5.40212264150943 33.92 183.24 117.85 21.8154987993888 0.64314560139707 1.1785 4.58389702291848 22.96%

Leveraged Implementation
Date $GC_F Sept $ES_F Sept SPY  Oct 100/125 Strangle
8/25/2011 1774 1163 3.6
9/3/2011 1881.6 1169.3 2.62
6.07% 0.54% 27.22% 32.75%