Month: February 2014

Submitted by Peter Tchir of TF Market Advisors,

I have two major concerns right not that I think everyone should be nervous about.  Actually I have lots of concerns, but most aren’t about the markets, and discussing them in this forum isn’t appropriate, so I will stick to my market related fears.

These are two risks that I see taking this sell-off further and faster than anyone else expects.

The Death of the Normal Curve

I think algo’s in general have had changes the distribution of returns.  That seems particularly true around the big Moving Averages.  Maybe it is just me, but I see so many conversations about the 50 DMA and 100 DMA these days that it seems that everyone is looking at them.  It might just be my streams, or it might just be that everyone really is that bored, or is looking for an excuse not to sell.

In any case, I think there are many more “entities” trading the moving averages (and other technical levels).  I think that has shifted the return distribution over time.

Let’s say in the good old days, there was a “normal” return distribution around the 100 DMA.  Since I am graphically challenged I will work with a very simple binomial distribution that illustrates the point.

Say there was a 75% chance of a bounce with a 0.5% profit, then there should have been a 25% chance with a 1.5% loss.  That would have created an expected value of 0.

People still trade it because they felt they had some other “advantage” that let them pick the bounces with a higher success rate.  Or pick those bounces that would generate higher returns.

Over time as more and more algos try to trade the same phenomena the success rate actually increases.

It becomes to some degree, a self-fulfilling prophecy.  If I am buying at the 100 DMA because it bounces and you are buying at the same price (for the same reason) then it is likely to bounce.  So what happens over time is the “win rate” increases.

Now let’s say you win 90% of the time, and the average profit is still 0.5% then that loss, which only occurs 10% of the time, should be 4.5%.  Yikes.

You can see how it would happen.  The 100 DMA at one time represented the entire market which was not overly biased towards technicians.  Shorts maybe covered at those levels because it seemed appropriate.  Longs doubled down because they had liked it there once before, so why not now.  All these charts are just a graphical representation of human behavior.

But now that has changed.  A lot of the people sitting on long positions bought for no other reason than it should go higher.  It wasn’t a long only manager adding to a position at levels they had once liked.  It was a twitchy algo buying because it has to go up.  One feature all those algo’s have is relatively tight stop losses.  They may all need to exit at the same time.  That might push us further than anyone expected.

While real money might add at the 100 DMA, maybe once they break through it and have all their gains from the past few months wiped out, they don’t add, or even sell.  Maybe the algo’s that sniff out weakness short.  Maybe that is why we don’t get a small gap down, but instead hit an air pocket.

So I am nervous that the support we think we have has been eroded by the types of trading that goes on, and that what should be a small sell-off based on the data, becomes a larger sell-off base on the positioning and types of trading we see in the market.

Treasury Weakness

In case you missed it this morning, we recommended covering the long bond long position (I do love saying that).

Before getting into why we are nervous, I have to admit I still think TBT might be the most insane “investment” out there.  2 times the daily move in any treasury seems silly.  These leveraged ETF’s have serious path dependency problems as it stands.  The “churn” of daily bounces hurts their returns.  That is common enough in treasuries.  Then it is based on some index (Barclay’s 20+ year treasuries) that is completely affected by the Fed’s positions.  The Fed owns significant portions of a lot of the bonds that are in that index, making pricing less transparent.  But that is solved by being short through bilateral swaps.  Okay, I use the term “solved” very loosely.  So you have path dependent leveraged risk to an index that isn’t fungible through bilateral swaps.  Shoot me.  Please just shoot me.

But shares outstanding for TBT continue to grow.  If ever any investment should be destroyed on principle alone, this is it.  It makes me want to go long the long bond, again.

But I can’t.  Not every “consensus” trade loses every day and I am very nervous that “something” is going on in the treasury complex.

Here are our concerns:

We have hit some target levels 2.60% on the 10 year and 3.55% on the long bond (or close enough)

 

We aren’t rallying as much as we “should” be.  Completely subjective, but this morning when futures were down 4 (how quaint that seems) treasuries were also lower.  It feels like there is real resistance here, and I’m not sure how things like TBT aren’t causing a massive short squeeze, but it appears that they aren’t.  So cautious here.

 

The prices paid on ISM was very high today.  The CRB index is getting higher by the day.  The dollar is weak.  So there are signs of commodity inflation, if nothing else, but that should help put a floor on how low treasury yields go.

 

Finally, and possibly most important, is that we are annoying most of the rest of the world.  Bernanke often said that trade barriers established during the great depression made the problem worse.  He urged government not to repeat that act, and they haven’t.  But his policies are starting to have that same impact.  Countries blame QE for their mess.  Countries are starting to question the sense of having a single reserve currency.

So I don’t like what is going on here.

What is worse, is that I do believe that if treasuries crack at all, then retail will exit high yield and investment grade bonds and with spreads already leaking there will be no hedge fund demand.  In fact, hedge funds will become forced sellers.  Then the real final bid, the pension funds and insurance companies, who are already fairly long risk, will hold off using their capital until the pain grows.

It will be the drop in corporate bond prices that cause the real problem, but it will be precipitated by a treasury sell-off.  One that we haven’t seen yet.  Hopefully we won’t see.   Hopefully some perception of “safety” and concerns about how weak growth will be will hold down treasury yields, but I am extremely nervous.

Positioning/Model Portfolio

We are selling the remaining 5% of SPY March 180 puts.  We want to sell them before they become completely intrinsic value.

We should probably sell XOVER protection, but will hold on to it for now (in no small part because it is now after noon and London has shut).

We might take some IG off later today (we added a tiny bit more on Friday around lunchtime).

I am very close to going short treasuries.  Not the long bond.  Maybe the 10 year.  Maybe the 5 year.  Maybe we do via interest rate swaps.  I am looking to see what expresses my concern the most with the least amount of damage if I am wrong.  This is difficult to pull the trigger on since you know my feeling on TBT and since I am bearish enough stocks that it is hard to get too jazzed up about a treasury sell-off.

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When the “impartial” Congressional Budget Office first attempted to predict the impact on the US labor force as a result of the administration healthcare ponzi scheme, also known affectionately as Obamacare and less affectionately by other names, it estimated that 800,000 Americans would drop out of the labor force by 2021. Moments ago it just revised that projection, admitting that it was off by the usual 100% or so: the hit to the US labor force due to Obamacare is now estimated to soar to 2.3 million through 2021, and furthermore the CBO just admitted that the enrollment rate will be dramatically below the White House’s baseline estimates, with 2 million fewer people signing up this year than previously estimated.

In brief, as the CBO admits (before it is forced to adversely reduce the numbers once more) the law will lead to 2 million fewer workers in 2017, 2.3 million in 2021 and 2.5 million through 2024. This represents a 1.5% to 2.0% reduction in the numbers of hours worked. As the WSJ recalls, CBO last year projected 7 million people would enroll for health insurance through health care exchanges in 2014, but Tuesday it said technical problems that plagued the program’s rollout forced it to lower its estimate by 1 million people.

“Those changes primarily reflect the significant technical problems that have been encountered in the initial phases of implementing the [law],” the CBO said. It said it couldn’t yet revise estimates for future years. CBO also projected 8 million new people would qualify for Medicaid and other expanded coverage this year, down from a 2013 estimate of 9 million people.

The health care law’s open enrollment process began in October and runs through March, and CBO estimated “the number of [people who sign up [for coverage] will increase sharply toward the end of the period.” Or not.

And here it is straight from the horse’s mouth:

The ACA’s largest impact on labor markets will probably occur after 2016, once its major provisions have taken full effect and overall economic output nears its maximum sustainable level. CBO estimates that the ACA will reduce the total number of hours worked, on net, by about 1.5 percent to 2.0 percent during the period from 2017 to 2024, almost entirely because workers will choose to supply less labor—given the new taxes and other incentives they will face and the financial benefits some will receive.

What does that mean?It means this: “reduced incentives to work attributable to the Affordable Care Act (ACA)—with most of the impact arising from new subsidies for health insurance purchased through exchanges—will have a larger negative effect on participation toward the end of that period.” Just don’t call it a welfare program.

The above in numbers:

The reduction in CBO’s projections of hours worked represents a decline in the number of full-time-equivalent workers of about 2.0 million in 2017, rising to about 2.5  million in 2024. Although CBO projects that total employment (and compensation) will increase over the coming decade, that increase will be smaller than it would have been in the absence of the ACA.

…

The number of people who will receive exchange subsidies—and who thus will face an implicit tax from the phaseout of those subsidies that discourages them from working—will be smaller initially than it will be in later years. The number of enrollees (workers and their dependents) purchasing their own coverage through the exchanges is projected to rise from about 6 million in 2014 to about 25 million in 2017 and later years, and most of those enrollees will receive subsidies. Although the number of people who will be eligible for exchange subsidies is similar from year to year, workers who are eligible but do not enroll may either be unaware of their eligibility or be unaffected by it and thus are unlikely to change their supply of labor in response to the availability of those subsidies.

The CBO’s mea culpa:

CBO’s estimate that the ACA will reduce aggregate labor compensation in the economy by about 1 percent over the 2017–2024 period—compared with what would have occurred in the absence of the act—is substantially larger than the estimate the agency issued in August 2010. At that time, CBO estimated that, once it was fully implemented, the ACA would reduce the use of labor by about one-half of a percent. That measure of labor use was calculated in dollar terms, representing the change in aggregate labor compensation that would result. Thus it can be compared with the reduction in aggregate compensation that CBO now estimates to result from the act (rather than with the projected decline in the number of hours worked).

 

CBO’s updated estimate of the decrease in hours worked translates to a reduction in full-time-equivalent employment of about 2.0 million in 2017, rising to about 2.5 million in 2024, compared with what would have occurred in the absence of the ACA. Previously, the agency estimated that if the ACA did not affect the average number of hours worked per employed person, it would reduce household employment in 2021 by about 800,000.25 By way of comparison, CBO’s current estimate for 2021 is a reduction in full-time-equivalent employment of about 2.3 million.

If you like your horrible 2010 forecast, you can keep your horrible 2010 forecast.

As for the most recent one, which too will be the source of comedy in one year’s time, here it is (link).

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Whether Treasury Secretary Lew’s words were meant to calm and chaosify the markets yesterday, his comments on the debt ceiling have sparked a notable sell-off in ultra-short-dated Treasury Bills. As we noted previously the 2/28 ish date appears to be the market’s bogey for now with the yield more than tripling from 3bps to 11bps in the last 2 days. CDS on the USA has also risen notably in the last few days with the 5Y now trading inverted to the 1Y cost of protection once again.

 

Major jump in T-Bill yields in the last 2 days as Lew brings back memories of October…

 

And USA CDS is on the rise (and inverted) once again…

 

As we noted previously:

This is what the X-Date projection looks like depending on the best and worst cash in/out scenarios:

 

 

Charts: Bloomberg

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