18/08/2011: VIX signals crunch time for the crisis

Summary:


Few charts on VIX - hitting historic, second highest ever, 1-day dynamic semi-variance range:
VIX itself above and intraday range below:

3mo dynamic STDEV showing emerging and reinforced trend up on semi-variance side:
And same for straight volatility (symmetric)
This, folks is a crunch time.

The reasons I bothered with this are here.

08/08/2011: What VIX tells us about today's markets meltdown

Let's chart what I called the Roy Lichtenstein-styled "KABOOM" moment for the markets today. Recall that by definition the CBOE Volatility Index (VIX) is "a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility."

Now, basically, VIX is as close to a pure price risk bet as we have. Again per CBOE: reported VIX index values represent "market estimate of expected volatility that is calculated by using real-time S&P 500 Index (SPX) option bid/ask quotes. VIX uses near-term and next-term out-of-the money SPX options with at least 8 days left to expiration, and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index."

Now to the charts.

Starting from the top, we have actual VIX itself - today's close at 48.00 which was:

• Still well below the historical max of 80.86 attained on 20/11/2008
• Well ahead of the historical average of 20.35 or January-2008 to present average of 27.21 or the average since January 2010 of 21.11
• Today's close VIX reading was 63rd highest daily reading for the entire history of the series and the highest since January 2010
• All 64 top readings (equal or above that attained today) were recorded in the period since January 2008.
  

Today's intraday spread of 35.65% is below Friday intraday spread of 45.52. However, the two readings are quite extraordinary:

• Intraday spread average for historical series is 3.01%, while since January 2008 through present intraday spread averaged 9.06%.
• Today's spread was 7th highest in history of the series, the 5th highest since January 2008 and the second highest (after last Friday's) since January 2010.
• Friday's intraday spread was the 5th highest daily spread in the history of the series and the 4th highest since the crisis start (January 2008)

To see just how extraordinary last couple of days are, consider two time horizons for volatility in VIX itself:
and a shorter horizon:
3mo dynamic standard deviation for today's close is only 433rd highest reading in the series history and the 60th highest since January 2010, while 1mo dynamic standard deviation is the 56th highest over entire history and the 5th highest since January 2010.

However, in terms of daily percentage changes, today's rise of 50% is the fourth highest daily increase since the beginning of the VIX history and the highest since January 2008.

In terms of 1mo dynamic semi-variance (measuring only variance for the days of increasing VIX index, in other words - only for those days when risk rises), the last chart above clearly shows that we are in for a treat in these markets.

A sight of carnage: GE

GE - that Titan of global economy - is under a threat of becoming the next AIG.Although the company is forecasting USD18bn in profits this year (on the back of its industrial arm), GE shares have now dipped below USD6.50, their lowest level since 1991. All due to the GE Capital exposure in the risky commercial and residential lending.

Since October, GE sold USD15bn in new shares and USD31bn in new bonds, cut down its loan book and reduced its reliance on short-term debt funding. GE has cut its dividend by 68% to generate additional USD4.4bn.

Sounds good? Not really. GE has set aside roughly USD10 billion in provisions for losses on its USD380 billion in receivables at the finance unit. The company loans total USD680bn against equity cushion of USD34bn in cash and USD36bn in assets. The latter is taking a hit in the current markets, implying today's equity cushion of only ca USD63bn and falling.

It would take a USD9bn hit to earnings and equity for GE were to write down its real-estate portfolio by 25%, according to UBS analysts. GE has transferred some of its real-estate holdings, into real-estate lending. As a result, its total real-estate assets increased USD6 billion, or 8%, last year.

But let us get back to the USD10bn provision. Here is my view on the share price going forward:

Assume they set aside cash (otherwise this set-aside is itself open to downward revaluations over time). This implies expected impairment provision is 2.63% of receivables. Globally, AAA rated CDOs carry the recovery rate of only 32% on face value, while for mezzanine vehicles the recovery rate is only 5%.

So, suppose GE gets a 25% boost on that via higher debt seniority and tighter loans management, etc. Assume the recovery rate of 40% on higher quality junk (hqj) and 8% on lower stuff. Take a blend on the book at 90% hqj, 10% 'stuff', this gives us an average - across-the-book - expected recovery rate of 37%. Suppose 12% of loans are under threat (rather generous in this commercial and residential real estate markets), allowing for some earlier writedowns that already took place. You have a required impairment provision of 12%*(1-0.37)=7.56% or almost 3 times more than the USD10bn they provided for.

This level of provisioning - if set in cash - will take us into a set-aside of an additional USD18.7bn on top of USD10bn set aside today, bringing equity down to USD17.3bn cash and USD34bn in assets or total equity of USD44.3bn - some 30% haircut. Assume deterioration in the assets part of equity pool at 1/4 of the rate of deterioration in broader assets, i.e. 3%pa, you have additional shave-off of 2% on equity, implying equity cushion fall will depress the overall share price by at
least 30% from today's level.

Now, I suspect that when they quote USD34bn cash equity today, they actually include the USD10bn provision into that as well. If so, the total haircut should be based on USD34.3 equity, implying a cut of 45.6% (provisions) + 2.5% (asset deterioration on equity side) = 48% on
today's share price.

So you have USD3.5USD as the equity-underpinned price target. And that is where the stock heading next, in my humble opinion...

Market view

US dividends are being cut at a record pace (see here) and this is a welcomed news as it marks the beginning of a turning point in the market. I do not mean the turning point for an upward swing in equity prices, at least not yet. I mean a turning point from the relentlessly accelerating down trend and into a flattening section of the U-curve.

Here is the logic - corporate profits are lagged at the very least one-to-two quarters from real demand. This suggests that an accelerating fall in the dividends reflects the economic reality of Q3-Q4 2008. Assuming the real side of the US economy is going to start settling into the bottom section of the U-shape correction sometime in February-March, the current reporting season will be pricing exactly this forecast. Any pick up in growth from the low figures of December-January will be a bonus point to Q2 dividends.

Regardless of such a pick up, equity markets downgrades in the next few weeks will bring share prices down to reflect dividend cuts.

This will set the stage for the next move. End of Q2 is likely to see some upturn in the US economy. Real GDP growth is likely to stay negative in annual terms, but the latter part of Q2 will be marked by a rise in growth from the lows of Q1.

Equity markets will lead this trend with a potential rally in late Q1 - early Q2. Dividend cuts anticipations for Q2 will already be priced in by then, so aggressive cost cutting measures - implying lower sensitivity of Q2 profits to any further economic slowdown in Q1 2009 - will provide some additional potential mid-Q2 boost to the share prices.

A late Q1-early Q2 rally will be a payoff to today's realism...

Renewing appetite for risk?

“I have some good news, at least for the intermediate term: Investors are slowly regaining their appetite for risk”, wrote Marketwatch’s Mark Hulbert in his today’s column (here)
“This represents a big shift from the situation that prevailed last fall, when investors became so repulsed by any kind of risk that the yields on safe-haven investments like Treasury bills actually went negative.”

But now, says Hulbert, with January effect in full swing, things are looking up – investors are looking for risk once again.

“Of the several straws in the wind that point to at least a partial return of a risk appetite, one of the more compelling is the recent relative strength of risky small-cap stocks over the more conservative large caps. So far this year through Tuesday night, for example, large-cap stocks (as measured by the Standard & Poor's 500 index (SPX: S&P 500 Index) have fallen 3.5%. Small-cap stocks, as measured by the Value Line Arithmetic Index (92040310), have declined by just 1.1%.”

Now, I am not convinced by Hulbert’s main argument.

January effect is a tax-minimization event, driven by heavier sales of shares with lowest capital gains potential to maximize losses in December (blue chips down) and re-balancing portfolio toward higher capital gains potential (small cap) in the new year. In normal years, movements correlate positively with risk, i.e. small cap – higher expected return, higher risk, blue chip - smaller expected returns, lower risk. But is that the case this time around? In other words, the markets might be going into smaller cap because the larger cap is actually relatively riskier (controlling for current valuations), not because they are seeking higher risk-return strategies.

Chart below illustrates Mark Hulbert’s point – at its right-hand margin. Indeed, the short-term performance by the two indices does suggest that the markets are placing more faith in the small-caps. But it shows that this was true for much of the 2008 with exception of the late autumn. In other words, if current divergence vis-à-vis S&P is a sign of new appetite for risk, what did the market have appetite for in July 2008 when small caps went up and S&P stayed relatively flat? Why did the price of risk implicit in the difference in two indices has fallen in April-June and July-early August? Were these the ‘turning’ points in underlying appetite for risk or just traditional bear rallies?
An alternative explanation for the ‘January effect’-like pattern observed is that investors' risk perception might have shifted. Consider the following scenario: You are in a market with four broad asset classes:

• large-cap,
  
• small-cap,
  
• corporate bonds and
  
• Treasuries.

You believe that too much risk-taking has taken place in the second half of December by pursuing a bear rally in S&P500 stocks and the Treasuries. If you move into relative safety, you will move into the two remaining assets. You will have an incentive to prefer the small caps if you believe that they have taken the heaviest beating to date (which they did – see peak to trough moves around September-mid November) and you invoke another powerful anomaly of the ‘Winner’s Curse”. The real question then becomes is what does the analysis of relative position changes in corporate debt and small cap shares tell us. The large cap stocks are irrelevant here.

Hence, what appears to be a renewed appetite for risk can be interpreted as a hedging strategy against rising risk levels and falling expected returns in the so-called traditionally ‘safer’ asset classes.

What Hulbert is right about is that one should not overplay the story too much. Instead, the return of the January effect pattern (or something else resembling it) might mean “that the stock market will gradually resume its normal function of assessing different securities' relative risks and returns, a function it couldn't fulfill when it was indiscriminately punishing virtually everything other than Treasuries.”

Yes, but… even if Hulbert is correct, the return to rationality in the markets will be bound to:
• trigger fresh downgrades in many companies and indices as corporate returns deteriorate throughout H1 2009, as the bath water gets muddier with longer recession; and
• this rationality will remain extremely fragile and prone to collapse every time the elephant in the room – the US Government – moves about.

Hulbert omits the latter issue, but it is non-trivial to his topic. We are in the changing political cycle – and with it – a prospect of a new stimulus that is bound to prop up smaller business. If, as is the case, Uncle Sam’s rescue packages for many blue chips were already priced into these companies valuations in late December, Obama's first 100-day sweetheart package for Congress is yet to be fully priced into stocks valuations. It might be that the ‘January effect’ is simply the reflection of this delay in recognizing that the next Uncle Sam's move will a stimulus for smaller companies?..