Fundamental Trading Diary

Fundamental analysis of the capital markets

Late June Review

American, Chinese, Indian and Japanese Stocks

American, Chinese, Indian and Japanese Stocks

The past several weeks have marked a divergence in the path of global indices.  With most of them actually down (21 out of the 23 I measure), Shanghai (+6.72%) and Taiwan (+0.24%) contrast with London (-4.52%) and Germany (-5.78%).  Starting from the 15th, and extending through Friday’s close, this marked the first time the number of global indices with 2 week gains had fallen negatively sustained for more than 2 days since the up-turn.  There were some shorting and convergence arbitrage opportunities, specifically in Malaysia earlier on in the divergent down-turn.  I suspect that ship has now sailed.  There are probably, however, convergence arbitrage opportunities in China (short) and Germany (long).

A look at volatility

My long-term volatility model — which takes the VIX value and discounts it for recent price movement — is still very pessimistic about future prices.

Volatility-Discount Model

Volatility-Discount Model

Implied volatility itself gives us two tells.  The first is that we are at a crisis low.  Despite this past week’s global stock markets drifting down, implied volatility still crept lower.  This, in conjunction with a strong China, is what led me to tweetIf I were a more active trader, I’d be buying equities for a bounce right now” on the evening of June 22nd after the market had lost -6.78% from the June 11 highs.  A fortunate call, but I’d be more lucky if I were a more active trader….

Implied volatility in context

Implied volatility in context

On the flip side, volatility is also at the stage where the market was before it really collapsed in September of 2008.  The market had a lot of uncertainty, but it underestimated the carnage which would follow.  Given that we’re at the same implied volatility as we were in August, just -9% off all-time highs, is it possible that future volatility is understated yet again?

One thing which we haven’t yet considered is the psychology effect on voltility premiums.  Options writers are the most sophisticated sub-group of investors, and they are also the only type of investor who actually have a historic edge over the market.  That said, they may write options to generate income for their bonuses now, and worry about the ramifictions/unwinding their positions later.

Implied volatility is also a far more reliable indicator at bottoms than it is at the top.  My conclusion is that volatility is understated.  Now is the time to buy volatility for the mid-term.  The macro-economics at play — chiefly the mortgage reset schedule — are going to return to the foreground.  In the very short term, I suspect the markets won’t do a whole lot, and this is probably a good time to scope out inflation sensitive assets which have been inordinately beaten down recently.

Fixed income taking away risk dollars

Stocks/Bonds Relative Strength Index

Stocks/Bonds Relative Strength Index

My bullish argument to explain the past few weeks of weakness is that the yield on bonds had become more attractive than domestic equities.  The risk chasing dollars haven’t receded so much as shift asset classes.  Wilfred Hahn made part of this compelling argument in his fantastic Global Chart Panorama (100 pages of nothing but charts you need to see).

There are major risks associated with various interest rates, however.  The Federal Reserve has allowed the Fed Funds rate to hit their target of 0.25%.  The recovery has shifted the structure of the lending market so that the US government is the source of all lending.  The balance sheet is providing the bid support for everything from government securities, mortgage backed securities to simply giving banks newly created money in the form of reserves to encourage them to lend.  (Note that this was tried in every crisis like this – namely Japan and the Great Depression, and it didn’t work either time).  Despite this, yields have been pushed higher, signalling that foreign investors, global soverign wealth managers, pension funds, and other very large long-term players don’t think they’re attractively priced.

At the same time, residential housing prices haven’t even hit their median prices for lows, and interest rates are fast threatening to derail the extremely modest recovery attempted there.

Equity valuation modestly improving

P/E and Future Return

P/E and Future Return

There are actually people in academia who disbelieve the idea that there are secular bear and secular bull markets.  Surprisingly, Professor Shiller is one of them.  He certainly has implied a belief that exist in other asset classes (like real estate).

The Big Picture wrote an article back in June of 2006 that had a 100 year chart showing that secular markets in equities were identifiable through the consistent expansion or contraction of the earnings multiple.  I tend to agree.  It is now obvious that the markets priced the S&P 500’s earnings very cautiously.

S&P 500 P/E Bottomed Out

S&P 500 P/E Bottomed Out

The P/E multiple has bottomed out for the moment.  It’s important to note that the mark of a new bull market, if indeed this is one, does not necessarily mean that stocks — particularly domestic — are a great asset to exchange your cash for.  In the most in the most optimistic of economic projections, US equities are going to trail emerging markets and commodities.  The financial sector, which recently accounted for half of corporate profits, is in the process of being neutered.  Asian banks, on the other hand, didn’t recently sufferDinghyTieupBelfastHarbor_080-754698 from the leverage gluttony, so they have plenty of reserves, margin and limited regulation.

The conclusion I come to is that this is the rising tide of inflation where everyone goes up, but there are certainly better boats to park your cash.



  • Chinese equities didn’t participate in the pause
  • Risk premium search still appears active in other asset classes than stocks
  • P/E multiples have, at least temporarily, bottomed
  • Implied volatility is lowest since Bear and Lehman collapsed


  • Implied volatility is the lowest since Bear and Lehman collapsed:  it mispriced the risk then, so is it now?
  • Macro hasn’t stopped falling off a cliff
  • Mortgage resets
  • 21 of 23 largest global indices have had negative 2-week returns since June 15

June 27, 2009 - Posted by | Uncategorized

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