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The CBOE SKEW Index just closed at its lowest level since October 2014 – but is tail risk in the stock market really that low?

We often stress the importance of taking indicators and data at face value as much as possible, avoiding the temptation to qualify or *asterisk* readings that don’t seem to fit the narrative. That said, it is also important to be familiar enough with an indicator’s behavior to recognize when truly atypical or outlier readings are issued. And speaking of outliers, a good example of such readings occurred last October in the CBOE SKEW Index, and possibly the other day.

As a refresher, SKEW is calculated from S&P 500 out-of-the-money options measuring perceived tail risk, i.e., an outlier event two or more standard deviations below the mean. Essentially, it measures options traders’ perceived risk of a major decline (more at CBOE.com). Typically, the SKEW ranges from 100 to 150. Readings close to 100 indicate that the perceived probability of an outlier return is negligible whereas readings approaching 150 suggest the probability is significant.

On October 12, 2015, the SKEW hit an all-time high reading of 148.92, indicating the highest perceived tail risk in the indicator’s history. The odd thing about the reading was that stocks were a mere 2 weeks into a rally off of the considerable depths of the September lows. Typically, extreme high levels on the SKEW have occurred with the market tight-roping at 52-week highs. This was hardly the case in October and those unusual circumstances caused us to question the normally noteworthy signal.

Today, we find ourselves questioning the reading in the SKEW once again – but from the other side of the spectrum. That is because, despite the ~12% stock market rally over the past 2 months, the CBOE SKEW Index closed at its lowest level (113.8) in a year and a half. This was also just the 18th reading below 114 since 2009.

 

If we take the reading at face value, it suggests good things to come for stocks over the short to intermediate-term. Consider the returns following the prior 17 SKEW readings below 114 since 2009.

Now these returns were accumulated during an overall extremely bullish environment. Nevertheless, median returns from 1 month to 6 months were far above the norm of the period, with a perfect 17-0 record 6 months out.

So why wouldn’t we take the recent signal at face value? Well, if you are wondering if perceived tail risk can really be at an 18-month low following a monster 2-month rally, you are wondering the right thing. A glance at the chart reveals that most, but not all, of the previous 17 SKEW readings since 2009 occurred near short to intermediate-term lows in the market. The recent reading on April 8 came with the S&P 500 some 12% above its 2-month low.

This does not match the circumstantial description of a market bearing a historically low degree of tail risk. In fact, of the now 18 SKEW readings below 114 since 2009, 12% is far and away the S&P 500′s largest margin above its 2-month low. There were 5 instances whereby the S&P 500 was 8% above the 2-month low. These occurred in July 2012 and May-July 2013. They also accounted for all but 1 of the negative forward returns in the S&P 500 from 3 days to 1 month out.

So again, we are loathe to dismiss data points just because they may not fit the standard profile. However, there are occasions when our radar goes off and we feel that, at a minimum, the data warrants some extra examination. Such is the case with the recent extremely low CBOE SKEW reading. Similar readings have historically come near lows of some magnitude in the stock market. However, present circumstances are, shall we say, skewed, enough to dampen the normally rosy expectations.

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More from Dana Lyons, JLFMI and My401kPro.

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After stumbling sideways around unch MoM for 3 months, US retail sales tumbled 0.3% in March (considerably worse than the 0.1% MoM gain expected) confirming BofA’s credit card data as we warned. March’s print is practically the weakest month since Feb 2015 and is unlikely to get much better given the dismally weak start to April, as we noted here. After 3 months of low-base bounce in YoY retail sales, March saw it collapse back to just 1.7% YoY – deep in recession territory.

March Retail Sales plunge…

 

As Auto Sales collapse 2.1% MoM… which should not surprise since US Auto Sales (SAAR), via WARD’s Automative Group, tumbled 3.5% YoY to end March – the biggest YoY plunge since July 2009 (pre-Cash-for-Clunkers)…

 

and perhaps just as problematic, Restaurants tumbled 0.8% – where all the hiring has been.

 

and if you are hopeful about April, Johnson-Redbook reported a 2.8% plunge in Same-Store-Sales – the worst start to an April since 2005.

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Last week, I heard that Jim Rickards had a new book out, called ‘The new case for gold’. I immediately ordered a copy, and I have to say, Mr. Rickards does an excellent job of refuting various myths surrounding gold, and more specifically laying out a groundwork for the role of gold in the global financial system in the future. This book is recommended.

As I finished reading Rickards’ new book, it hit me that his projected ‘golden’ future has enormous implications for the financial markets. It struck me that when a real buying frenzy occurs in gold, the market would be running out of gold for immediate delivery. The term ‘precious metal’ would get a whole new meaning to it. This scenario would have major consequences for investors, as they couldn’t protect their capital with gold anymore.

But before I go there, let’s look back at history, like Rickards does, and research why gold stocks have become the most hated equity class on the planet. It all start right after the turn of the century. Gold was ending its multi-year bottoming phase, and gold equities were cheap as dirt back in those days. The market started bidding up gold stocks, as they became a value play. With the first bull cycle in gold picking up steam in the first part of the last decade, prices in gold stocks went ballistic. Going from a deep discount to a full valuation in 07-08. But still, this was not a crowded area in the market. Gold stocks were not popular, at all.

Then, the credit crisis hit, and the general stock market crashed. Gold stocks crashed even more so, again tumbling into deep discount territory. And that’s when the general investment public started noticing gold stocks, as gold didn’t crash along with the general stock market. Gold just corrected, nothing more, nothing less. Investors started bidding heavily on gold stocks. The sector made an impressive V-shaped move, fourfolding in two years. This time around, gold stocks were on every investors’ radar. Deep discount became hyper-valued.

And when hyper-valuation arrives, trouble looms. After peaking in 2011, when gold prices topped, gold stocks literally cratered. Not one time, but many times after. And for good reasons. Investors noticed that these companies were printing more paper (shares) than digging dirt. Management wasted good money, throwing it all away for mall investments, overpaid acquisitions and fat bonuses. The sector became a sick part of the market, much like technology did after its bust in 2000.

Nowadays, gold stocks have become the most hated and abandoned area in the market.

So that’s when it hit me. A new case for gold would also create a new case for gold stocks. Because, if gold would again become the most precious asset in the world, who wouldn’t want to own the companies that dig the yellow metal?! As gold gets scarce for investors, a full-blown buying hysteria could hit gold stocks. Ownership of these equities would be the only way to get ownership of physical gold, even if the gold is still in the ground.

Investors would be paying up for a premium on the assets of these companies, but there is more to gold stocks than only gold. Gold stocks are companies that earn income and have a cashflow. This cashflow will manifold, in case of a gold price going much higher in the scenario which Rickards lays out. How much higher is anybody’s guess, but I could envision gold going to $5,000 per ounce (and beyond). This would send the cashflow for gold producers ‘to the moon’. Throw a revaluation on top of that, and you could see gold stocks going to levels no man has ever seen before. In this scenario, the Gold Bugs Index – in short ‘HUI’ – could elevate towards 2,000, maybe even 3,000. Currently, the HUI stands at 200…

So while there is a new case for gold to be made, this is even more so the (new) case for gold stocks. This segment is ready to emerge in a new, major bull wave, going from the current deep discount to a fully valued level, which again could result in a tenfold move, like the one we saw in the first part of last decade. As the new book of Jim Rickards is on my ‘recommended reading’ list, I also recommend reading the Gold & Silver Report from Secular Investor, which is a monthly specialized publication for the gold stock sector, and consists of a Premium Shortlist of the 40 Best Gold & Silver Stocks.

Nico Pantelis, Head of Research

Secular Investor

Secular Investor offers a fresh look at investing. We analyze long lasting cycles, coupled with a collection of strategic investments and concrete tips for different types of assets. The methods and strategies are transformed into the Gold & Silver Report and the Commodity Report.

Follow us on Facebook @SecularInvestor [NEW] and Twitter @SecularInvest

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One month ago we were quite amused by what at that time was one of the most ridiculous short squeezes we have ever seen when the stock of Peabody Energy, exploded higher from $2 to about $6 in days on… nothing.

Many scratched their heads at this move as nothing fundamentally had changed in the company’s deteriorating operations, and its bonds are among the most distressed issues trading currently. The move was even more bizarre when just a few days later Peabody warned it may file for bankruptcy protection imminently.

And earlier today, it did just that, when in a historic event, one which is perhaps the lowlight of the sad demise of the US coal industry, U.S. coal giant Peabody Energy, the world’s largest coal producer, which employs 8,300 workers, filed for bankruptcy on Wednesday, the most powerful convulsion yet in an industry that’s enduring the worst slump in decades. The stock has finally responded accordingly.

The company filed Chapter 11 petitions for most of its U.S. entities in U.S. Bankruptcy Court in St. Louis Wednesday, listing $10.1 billion in debt. All of Peabody’s mines and offices are continuing to operate and are expected to continue doing so for the duration of the process.

In the bankrutpcy statement Peabody lamented its sad fate: “The factors affecting the global coal industry in recent years have been unprecedented,” Peabody said in the statement. “Still, multiple third-party estimates project that both the U.S. and global coal demand will stabilize. Coal currently fuels approximately 40 percent of global electricity and is expected to be an essential source of global electricity generation and steel making for many decades to come.”

But it is rapidly dropping, as nat gas use soars as a cleaner alternative.

The company listed debt totaling $10.1 billion and assets of $11 billion in its court filing. To help it fund operations in bankruptcy, the company has agreed to $800 million DIP loan arranged by Citigroup.  The bankruptcy leaves uncertainty around Peabody’s $1.47 billion in environmental liabilities. Under a federal law enacted in 1977, mining companies must post surety bonds or other collateral that cover future mine cleanup costs unless their balance sheets are strong enough to qualify for an exemption known as “self-bonding.”

A brief timeline of the venerable company comes courtesy of Bloomberg: founded in 1883 by 24-year-old Francis S. Peabody with $100, a wagon and two mules, the miner is now the largest private-sector coal company in the world, with customers in 25 countries and about 8,000 employees, according to its website. It joins at least four other coal companies that have sought bankruptcy as the industry endures its worst downturn in decades – a result of tougher environmental policies, a flood of cheap natural gas and a global glut of metallurgical coal that’s dragged prices for steelmaking component to the lowest in more than 10 years.

BTU’s default is just the beginning: “The outlook for coal players remains bleak,” said Sandra Chow, a Singapore-based credit analyst who tracks coal producers at CreditSights Inc. “Any recovery remains a long way from here.”

The immediate reason for the bankruptcy is that the price of metallurgical coal has tumbled about 75% since its 2011 peak. That’s been particularly painful for Peabody, which spent $4 billion in 2011 to acquire Australia’s MacArthur Coal Ltd. in an effort to expand its sales of the steelmaking component. No Australian entities are included in the filings, and Australian operations are continuing as usual, according to the statement.

U.S. coal production peaked in 2008, at 1.17 billion metric tons. In recent years, it’s plunged and may fall to 752.5 million in 2016, the Energy Information Administration projected in its monthly Short-Term Energy Outlook released Tuesday.

In an indication of how quickly the underlying fundamentals can shift, as recently as October 2014, Peabody executives were optimistic, saying the worst might be over and investors were encouraged that coal pricing may have hit a bottom. The worst was not over, and the uptick never came.

Last year Peabody began cutting jobs and looking to sell assets. The planned sale of its New Mexico and Colorado assets was terminated after the buyer was unable to complete the transaction, according to Wednesday’s statement.

Full bankruptcy filing below

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The ridiculous headline risk that is whipsawing oil showed up this morning once again. WTI slide as much as $41.26 earlier on news that Iran’s Oil Minister Bijan Namdar Zanganeh wouldn’t be attending the April 17 meetings in Doha, however just moments later it was reported that Iran’s OPEC Governor Kaempour will be attending and losses were largely erased.

Elsewhere, BofA is out with a report saying to “Reduce risk heading into the Doha meeting.” The bank has developed four possible scenarios, and say that freeze or no freeze, due to a drop in US supplies and rising global demand the oil market is already rebalancing and project oil prices to trade on average above $50/bbl next year.

Truth be told, there is hardly any information on what will be discussed at Doha this Sunday. So in this note we develop four possible scenarios: back to a price war, no output freeze, a soft output freeze, and a hard output freeze with some enforcement mechanism. In our view, the last two scenarios would send Brent prices above $50/bbl in relatively short order, while the first two outcomes could lead to a price drop below $40/bbl. Having said all that, the global oil market is rebalancing, freeze or no freeze, due to a drop in US supplies and rising global demand. Stocks are set to draw structurally starting in 4Q16, in our estimates. So we still project oil prices to trade on average back above $50/bbl next year.

However, politics could trump economics introducing a bearish outcome as a possible scenario if Saudit Arabia doesn’t play ball, which could see oil retrace to the $30-35/bbl range. Incidentally Saudi Arabia hit the wires this morning with reports Oil Minister Ali al-Naimi said “an outright production cut is out of the question, forget about this topic”.

In the very near-term, however, a bearish outcome in Qatar is a possible scenario. While we see room for cooperation between OPEC and Russia, we also acknowledge that Doha could end up being a repeat of the December OPEC meeting. In other words, Middle East politics could once again trump oil economics. So should Saudi announce an additional output expansion in response to Iran’s return to market, Brent prices could retrace to the $30-35/bbl range. But even under our base case of “no output freeze”, long positioning is sufficiently stretched to warrant a near-term pullback below $40/bbl. Given the uncertainty, we advocate reducing longs ahead of Doha.

This is where it gets interesting because as BofA notes, Russian oil production is set for a decline sequentially from Q1 due to lack of investment and accelerating field decline rates, meaning that in their view, any cuts would have to come from the Saudi’s, and based on comments this morning this seems like a very remote possibility.

 

There is one saving grace perhaps that there could be a deal made to freeze output. Russia and Saudi Arabia have middle ground in that below $50/bbl they both are impacted on the current account / revenue side of things.

     

 

In summary, BofA has set four possible outcomes that come out of the Doha meetings, with no production freeze being the most likely outcome, but price war being possible as well – both bearish for oil.

Finally, and perhaps most important, is that OPEC came out this morning with a warning on perhaps the biggest wildcard of all: global demand for oil, which OPEC now declining. The now defunct cartel sees 2016 demand growth ~1.2m b/d vs previous estimate of 1.25m b/d.

Cited by Bloomberg, OPEC believes that weakness in Brazil’s economy, the removal of fuel subsidies in the Middle East and milder winter temperatures in the northern hemisphere could prompt further cutbacks, the group said.

“Current negative factors seem to outweigh positive ones and possibly imply downward revisions in oil demand growth, should existing signs persist going forward,” the organization’s Vienna-based secretariat said in its monthly market report. “Economic developments in Latin America and China are of concern.”

Perhaps this is just posturing in hopes of actually bringing the parties together to reach an agreement to freeze output. However if BofA’s most likely scenario plays out, and demand continues to fall, who knows how far we fall. If that’s the case, it may be a good time to check in with the Dallas Fed and ensure they aren’t telling banks how to handle energy loan exposure.

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• China trade surprise gives stocks a lift (Reuters)
• JPMorgan profit hurt by drop in investment banking revenue (Reuters)
• About 40,000 Verizon workers launch strike (Reuters)
• Regulators Set to Reject Some Big Banks’ ‘Living Wills’ (WSJ)
• More Startups Are Getting Lower Valuations Than Joining the Billion-Dollar Club (BBG)
• Closures and court cases leave Turkey’s media increasingly muzzled (Reuters)
• PBOC Seen Averting Cash Shortage as $155 Billion Leaves Market (BBG)
• Mossack Fonseca Says It’s Cooperating After Panama Office Raids (BBG)
• Tax-Rule Changes Ripple Widely (WSJ)
• VW says management bonuses to be cut significantly (Auto News)
• IMF Sees No Cause for Japan to Intervene Now in Currency Market (BBG)
• China Steelmaker Misses 3rd Bond Payment as Defaults Spread (BBG)
• Syrians vote for parliament as diplomacy struggles (Reuters)
• Who Loses the Most From ‘Brexit’? Try Goldman Sachs (WSJ)
• Coal Slump Sends Mining Giant Peabody Energy Into Bankruptcy (BBG)
• In Libya, Islamic State struggles to gain support (Reuters)
• Inside the Nondescript Building Where Trillions Trade Each Day (BBG)

 

Overnight Media Digest

WSJ

– Regulators are set to reject the so-called living wills of at least half of the U.S.’s systemically important banks, including J.P. Morgan Chase & Co, sending them scrambling to revise plans for a potential bankruptcy, according to people familiar with the matter.(http://on.wsj.com/1Vl4q2K)

– The Treasury Department’s new corporate rules will reach far beyond the few companies that moved their legal addresses to low-tax countries, forcing many firms based in the U.S. to change their internal financing strategies and tax planning. (http://on.wsj.com/1TQkMiR)

– A large holder of Valeant Pharmaceuticals International Inc’s bonds called a default as a result of the Canadian drugmaker’s failure to file its annual report earlier this year, adding to the litany of woes it faces. (http://on.wsj.com/1VTibEJ)

– Chip maker Integrated Device Technology was the subject of a mysterious regulatory filing Tuesday, submitted by individuals claiming to own a chunk of the company and looking to buy the rest of it at a steep premium. (http://on.wsj.com/1qPDifX)

– The Central Intelligence Agency and its regional partners have drawn up plans to supply more-powerful weapons to moderate rebels in Syria fighting the Russia-backed regime in the event the country’s six-week-old truce collapses.(http://on.wsj.com/1YsO9Hb)

 

FT

Oil services provider Schlumberger is cutting back on some of its activity in Venezuela due to insufficient funds. (http://bit.ly/1T2s4xu)

Deutsche Bank AG has frozen plans to expand in North Carolina after a law that overturns protections for gay people. (http://bit.ly/1T2sfsQ)

U.S. House of Representatives Speaker Paul Ryan ruled himself out as a potential Republican presidential nominee, ending speculation that he could be a choice if Donald Trump and Ted Cruz failed to win enough delegates. (http://bit.ly/1T2sEeT)

 

NYT

– As Puerto Rico has spiraled toward possible bankruptcy, the island’s sole representative in Congress has seen his family wealth swell, thanks in part to Wall Street companies that have sought to capitalize on the island’s financial crisis and have hired his wife to advise them. (http://nyti.ms/1YsNUvN)

– The Swiss authorities said that they had started a criminal investigation into two officials in charge of a sovereign wealth fund in Abu Dhabi, in the United Arab Emirates, as part of an inquiry into the financial transactions of the troubled Malaysian state investment fund 1Malaysia Development Berhad. (http://nyti.ms/1SyfLWH)

– The world’s finance ministers opened their annual spring meeting on Tuesday facing dampened expectations for global growth and warnings about financial risks and political movements toward nationalism and protectionism – in the United States and abroad. (http://nyti.ms/1WqTkc4)

– European Union officials waded into the fight against international tax dodging, calling for the world’s biggest companies to disclose more data about their tax arrangements with the bloc’s member governments and to share information about offshore havens where they shelter money. (http://nyti.ms/1SM29Yt)

 

Britain

The Times
   
Inflation has risen to its highest level in nearly 18 months, with prices pushed higher by an early Easter holiday and a rise in airfares, the Office for National Statistics said. A 22.9 percent rise in the cost of flights in March was largely responsible for the better-than-expected 0.5 percent increase in the consumer prices index, the statistics office said. (bit.ly/1Xu46fV)
   
Royal Dutch Shell has signalled that it is likely to sell some of its older North Sea assets. Ben van Beurden, Shell’s chief executive, said that the company would have to consider its operations in the region as he sets about delivering the $30 billion of disposals earmarked when announcing the 36 billion pound acquisition of BG Group last year. (bit.ly/1NniSzn)
   

The Guardian

B&Q is offering workers two years’ compensation and further negotiations over their pay packages after nearly 136,000 people signed a petition against the retailer’s planned cuts to employee benefits. (bit.ly/1RSw6JW)

Tax investigators from 28 countries will meet in Paris on Wednesday to launch an unprecedented international inquiry following the publication of the “Panama Papers”. (bit.ly/1NmSSEr)
           

The Telegraph

Major Tory donors are preparing to fund a grassroots campaign to leave the European Union following David Cameron’s decision to spend millions of pounds on a pro-EU leaflet, the Telegraph can disclose. (bit.ly/1oVyJ1V)
   

Amazon.com Inc is in talks with British broadcasters to add their channel brands and programmes to its streaming service. The company is attempting to adapt its American Streaming Partners Programme to the UK media market and make its Prime Instant Video service and Fire TV set-top box hardware into a more credible alternative to Sky and Virgin Media, and give it an edge over Netflix Inc. (bit.ly/1SLO1yl)
   

Sky News
   
Large companies operating in the European Union will be forced to publish key information on the profits they make and taxes they pay in each EU country under plans published on Tuesday. (bit.ly/1S50EVm)
   
Brexit could cause severe damage to the global economy, the International Monetary Fund has warned. The IMF used its closely-watched World Economic Outlook report to slash its forecast for UK economic growth and warned if Britain were to leave the European Union it “could do severe regional and global damage by disrupting established trading relationships”. (bit.ly/20zOCcf)
   
The Independent
   
Greater transparency could be imposed on multinational companies operating in the European Union after the European Commission unveiled plans to require all large firms to disclose their profits earned and taxes paid in each of the bloc’s countries, as well as in overseas tax havens. (ind.pn/1MrQQrK)
     
A formal inquiry is to open into the UK Home Office’s treatment of international students after Home Secretary Theresa May wrongly deported almost 50,000 students in the wake of the TOEIC English exam scam. (ind.pn/1SLtwSe)

 

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Going into today, everyone’s attention was focused on the JPM earnings report, the first big bank to report, on concerns about the profitability of the banking sector. And sure enough, as the chart below shows, going into JPM’s earnings announcement, EPS expectations had been drastically cut to account for what was clearly set to be a painful quarter for banks.

 

Which is probably why there was a sigh of relief, when moments ago JPM reported that it had beat expectations of a $1.25 print, when it announced $1.41 in adjusted EPS, with total revenue sliding by $700 MM to $24.1 billion but also beating lowered expectations of $23.8 billion. The largest U.S. bank by assets reported a profit of $5.52 billion, or $1.35 a share before 6 cents in adjustments, a drop of 6.7% compared to the profit of $5.91 billion, or $1.45 a share, in the same period of 2015.

 

Where the market was particularly pleasantly surprised, was that despite the drop in markets trading revenue of -13% to $5.718BN and the slide in investment banking revenue -19% to $2.417B. And while FICC trading revenue slid by $557 million, or 13% YoY, to $3.6 billion, this was well above the estimate $3.23BN print. On the other hand, investment banking revenue of $1.2 billion missed estimates of a $1.36 billion print.

 

This was JPM’s commentary on the results:

Banking revenue

• IB revenue of $1.2B, down 24% YoY driven by lower debt and equity underwriting fees, partially offset by higher advisory fees
• Lending revenue of $302mm, down 31% YoY, reflecting mark-to-market losses on hedges of accrual loans and lower gains on securities received from restructurings

Markets & Investor Services revenue

• Markets revenue of $5.2B, down 11% YoY
  • Fixed Income Markets down 13% YoY, reflecting an increase in the Rates business which was more than offset by lower performance across other asset classes
  • Equity Markets down 5% YoY
• Securities Services revenue of $881mm, down 6% YoY
• Credit Adjustments & Other, a loss of $336mm, on wider credit spreads

Expense of $4.8B, down 15% YoY, primarily driven by lower compensation and lower legal expense

But even as trading revenues were modestly better than expected, the one item everyone was looking for was to see how much additional reserves JPM would build in light of the deterioration in the energy sector. Here, JPM reported that it had built Oil and Gas reserves by $529 million, a key component of the the $773 million in wholesale credit costs.

JPM also reported that within its investment bank, it took out Credit costs of $459mm, primarily reflecting higher reserves driven by Oil & Gas and Metals & Mining, while credit costs in its commercial bank rose by $304 million also driven by O&G reserves.

Finally, at the firm wide level, $JPM reported 14.0B of loan loss reserves at March 31, 2016, down $0.1B from $14.1B in the prior year, reflecting improved credit quality in Consumer offset by increases in Wholesale, reflecting the impact of downgrades in the Oil & Gas and Metals & Mining portfolios.

 

However, perhaps reminding that not all is well, JPM’s consolidated loan loss reserve was a material $439 million greater than the preceding quarter and the biggest reserve build in six years, since Q1 of 2010.

Finally, here is JPM’s outlook:

• Expect 2016 net interest income to be up ~$2B+ YoY
• Expect 2016 noninterest revenue to be ~$50B, market dependent
• Expect 2016 adjusted expense to be $56B+/-
• Expect 2016 net charge-offs to be ?$4.75B, with the YoY increase driven by both loan growth and Oil & Gas
• Expect Securities Services revenue to be ~$875mm per quarter for the remainder of 2016, market dependent

Full JPM presentation below

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