It seems to me like world markets are fairly stuck. Europe is getting pretty much nowhere on the turns of the indices, Bloomberg announced yesterday with much fanfare that a new post 2007 high had been made (with a few point’s worth of margin) in the Dow Jones Industrials -not the S&P500 mind you – and Asia is getting the same treatment showing really well in the Greater China region, although the inflation rush out of Japan 10 weeks ago seem all but gone from the Nikkei 225. To wit, the HSI pretty much has been at 21 000, give or take 600, for the last two months.
Given the little bit of push, and how the shorter-term stochastics at least are flashing overbought as we are near the top of the ranges everywhere outside Japan, is it time to leave money management to a cute nursery rhyme? Bloomberg seems to think so in what has to be probably one of the most unintentionally funny things ever posted by them: “Sell, because that’s what the statistics say, you’re expected to move downwards slightly or insignificantly, but why take the risk?” followed by “But the market could also go up, according to the statistics. Finally, we recommend that you know about sell in May and go away, but be aware that there is a chance the market might rally.”
Gee, you need statistics and harebrained election cycle analysis to come to that conclusion? Efficient Market Hypothesis indeed…
Well, truth be told, I’m actually going to save myself some of the much warranted barrage of “where the **** were your posts when the market was sour in the last two months?” and come outnot saying why the markets will rally but instead say that we have muddle-through in terms of index valuations for a while. The most important point though is of course how to profit from this.
It is pretty much absurdly low no matter the market. Ok, Europe is the odd man out, but look at the Hong Kong, New York, or Tokyo bourses’ volatility indices, and tell me you don’t see a good opportunity to put down some straddles?
But let me first get down on the case of why I don’t think the market will move further. The asset manager in me gets really giddy at these times, so bear with him.
Most importantly is that we still have austerity overhang, and probably very few broad market growth catalysts. Tautologies, I know, but read on. Earnings? Margins are good, and everyone’s talking mild double dips, so I don’t see either top-line or bottom line growth, especially if the US households are getting their balance sheets somewhat repaired, and don’t even get me started on the different governments in the Euro zone.
On the other hand, liquidity is not so much the problem (it never was, no one has been willing to say the S-word for the last 5 years though…) so there should be no “long squeeze” of margin calls and collateral posting. China hard landing? Like 7% growth? Whoa, harsh indeed, and yes it does seem like they’re getting to where they want to be in terms of housing (dampening, rather than restricting, and differentiating between stimulating first purchases and discouraging seconds) and the banking sector could come in slightly better as well with gradual easing. On top of that, the currency is getting into a more wide band, and gives some indication of having a – however artificial, due to willingness of Chinese to get their hands on foreign financial assets – equilibrium around USDCNY 6.30. As soon as enough yuan has gotten out of the hands of the Chinese yield-hungry investor/speculator, and there is a little bit more of a playing ground in off-shore yuan, maybe we can see that 12% appreciation over one to two years that Romney is referring to. All in all, the worst seems to be baked in, and with any luck earnings should start to run through the Chinese export machine again unless there is cataclysmic conflagration in Spain/Italy. Quite a bit ot ask for, but then again, china has been at this in both the US and Europe for the better part of four years now and done mighty fine weaning off their reliance on their current account surplus. (See Bloomberg link on Romney policies.)
One other reason for this view, again mainly in Hong Kong, is that the HSI volumes are really low and rather uninspiring, although today represented the completion of an inverse head-and-shoulders pattern that could technically take the stock much higher. Again, even though this is a holiday period, there has not been a significant drop in volumes which would be good unless the base wan’t already so low (regularly posting HK$40 – 50bn turnover isn’t very healthy…) Unless there is a significant volume return anytime soon (hello summer!) I would advise against taking large directional bets, particularly on the upside as everyone seems focused on the US indices’ miraculous outperformance.
Where does that leave asset managing then?
From a pure strategy perspective, I don’t think there’s been a better time to differentiate yourselves from the crowd in recent memory, and that there are quite a few good ways to play this stale market. Some absurd (and absurdly high) correlations and blind beta reliance is finally coming undone and gives some alpha back into the money management style. So, lets dig in. Strategies for this market I’d love to use:
Long near term implied volatility: well, you could probably guess this one from before. Fairly straight forward. Again, try to be a little bit more differentiated in terms of which products/indices you choose, as the skew is probably going to pick out some huge implied volatility to the upside which may not be as easy to realize as the ditto on the downside. Short longer dated volatility if you need to raise cash – the idea is to get cash out quick on any volatility spike, cover costs and enjoy the marginal earnings as diffusion will pretty much ensure that long term volatility takes account for a better proportion of potential volatility and doesn’t really sink or swim as much as the near term. The extra gearing you could get out from the short term could be worth it, as long as you don’t commit all your capital. How about bar-belling the moneyness levels on the short end (vega exposure plus some mitigation of the theta) coupled with OTM issuance? Feel free to adjust exposures according to your other views, but the idea is to squeeze enough out of a short term move to finance any potential outstanding demands at the end of the strategy.
Alternatively, buy a long-dated OTM straddle and fit a fixed-exposure fund “inside”. I find this to be particularly appealing with the HSI as earnings are still high compared to the capitalization values. What I mean is that you use a straddle (say, 10-15% either side, maturity out in 2013) and then put down a fixed value of money physically in the index, and reset to this initial value of exposure at given intervals (3% of index move, weekly, or some other metric, you choose). Yes, this uses a lot more cash and doesn’t enjoy margin, but the idea is fairly simple: if the market moves sideways, you’ll get more percentage-wise on the way up than you lose on the way down. The risk is linearized (you can lose infinitely much money and you don’t earn at an exponential pace) but both of these contingencies are covered by your deep OTM straddle, and you can pretty much discontinue the strategy and cash in on the volatility alone if the market moves 10% either way (representing 19 500 or 24 000 in the HSI) while theta isn’t eating you as voraciously on a proportional basis.
This is where it gets fun. Apply generously to mainland Chinese companies listed on the HK bourse, although I do believe this is relatively universal at the moment. Pick out a selection of the highest-beta stocks you can find, rank them in terms of performance and long the three best, short the three worst barring extremely good fundamentals, and write index OTM options that mature at the end of your view for how long the market can trudge along. The general rationale for why I would pick this style is that – under the assumption that a severe paradigm upheaval equivalent to the imminent fall of the USA, China or Japan is not on the horizon – a lot of the companies that currently do well won’t fundamentally change their prospects, and similarly with those that do badly. Let the long/short mechanics work in your favor, the beta provide the extra leverage to your strategy and use the proceeds from the options writing as a buffer in case of your analysis being wrong. Then again, since you’re already long/short momentum plays with high beta, the payout probability is likely something you can earn a handy dime on either way.
Good, old-fashioned fundamental research. As I noted above, correlations are breaking spectacularly, and we’re getting a big bit of scramble to reallocate back to fundamentals as correlation was the previous king. This will go on for a while given how extreme and how long the correlation market reigned (never seen it run for six months like that before…) so there are still a lot of fund managers that need to get out of whatever positions they’ve taken before the 1H 2012 rolls to a close. Pick a few red chip industries in China, see the base fundamentals (regulation, margins, weather for agricultural products, etc) and go long, while getting a put on the index. Or, why not just look into Macau gambling where revenue came in really strongly – again.
I truly do believe that this is the fund manager’s time to show why they’re on payroll, so the coming few months will be highly interesting as it should lead some clues into how asset allocation will pan out for the rest of the year with the biggest boys. Pretty much, how long are runners allowed to run? How much momentum and differentiation starts creeping into the index components? Will the ideas of what is fair fundamental value shift firmly away from the P/E or EV/EBITDA regimes and focus on potential growth and management expectations that rule the DCF spectrum?
Good summer viewing either way!