This Is The SP500. This Is The SP500 On Crack

Remember the anti-drug commercials with the frying pan and the egg? As of late it would appear as though investors have forgotten that you are supposed to say NO to drugs, especially during market hours. In the chart below we have a rolling 21-Day Standard Deviation for the SP500 as well as the 50-Day moving average of that number. On a one month basis we are at the second highest reading in over 10 years, second only to the crash of 2008. Looking at the smoothed 50-day moving average we are actually at a new high. The close to close movement is running at an average of 2.34%. (Click on chart to enlarge)

SP500 Rolling 21-Day Standard Deviation

How can you use this information? There are a few trading strategies you can investigate from this such as selling options or putting on some arbitrage positions betting the spreads will come back in. For most investors however the more important thing to see here is that risk management is not only paramount to your investing/trading but it is a moving target. As a general rule when volatility is high, or extremely high as the case may be, you would want to look at using relatively loose stops, scaling down your position sizes, lowering your leverage, raising cash, etc. While most, maybe all, long time traders already use good risk management we have found that far to many new traders don’t adjust their trading when the market gets stoned. Consequently they lose far more money then they have too. Following tools like this can help you to smooth out your returns and stay in the game.

Happy Trading,

Disclaimer-We always use risk management and own the domain name

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Is The Rise In LIBOR Due To Liquidity or Growth?

With the recent rise in LIBOR we have been reading a lot of concerns over what it all means.  The two main arguments that we have seen is that either it is due to liquidity concerns or it is due to the supposed recovery in the United States economy.  For many reasons we obviously fall on the side of this being led by fear and liquidity rather than due to a recovery and an expectation of the Fed raising rates anytime soon.

3-Month LIBOR


The first thing that would lead us to assume that this is due to panic and not recovery is the way in which LIBOR is rising.  What we mean is that if you compare it to T-Bills it usually trades very much in line except in times of fear.  Looking at the chart below you can see that the last three times that it has diverged was also when we had banking system fears.  The top in the summer of 2007 which kind of started off the whole mess, fall of 2008 when the world seemed to be falling apart in front of us, and then in late winter 2009 when we already had the ZIRP in place but it looked like things might be getting even worse.  Of course once things got back on track and the end of the world as we know it was at least postponed the relationship got back in line with LIBOR at a slight premium to T-Bills like regular times.  Another thing that we find odd is that if LIBOR is rising on a recovery then why aren’t T-Bill or  2-Year Treasury yields climbing?  Would bond investors not drive yields higher if they thought this recovery had legs?

3-Month LIBOR and T-Bills


Looking at other money market spreads shows much of the same thing.  Namely that spreads are going up, this by the way is usually not a good thing.  Looking at the TED spread, LIBOR-OIS spread, and 90-day commercial paper-T-Bill spread you can see that they have all been climbing since the Greece and EU problems really started to gain some attention.

Money Market Spreads


Now lets look at some spreads in other nations.  It should come as no surprise that they are also on the rise.  In the first chart we have the EURIBOR-OIS spread, after spiking higher it has continued to inch its way basis point by basis point wider and wider.



Next up is the TIBOR-OIS spread.  As you can see it is also rising although a lot slower then in the US or in the EU.  As we will see in a few charts however that is how it always is.



Finally we have the UK LIBOR-OIS spread. Again it should not be much a surprise that it too has been climbing quite a bit.  The UK is weak and its nearest mega-economy the EU is weaker.  Banks are and should be scared.



Looking at the three spreads over the last few years you can see in the chart below that the global banking crisis affects them all.  Another thing worth noting is that Japans spread (the yellow line) may be rising slower but the swings have been far more muted the whole time.  Of course Japan has been dealing with a broken banking system for almost two decades now.



We will end this post with one last indicator that we follow closely and that is the VIX.  This volatility index is simply an average of stock, bond, currency, and commodity volatility indexes.  If most asset classes are seeing an increase in volatility it rises and if most are declining it goes down.  As you can see in the chart below it has been going up the last few months as many market participants are once again focusing on risks.

Average VIX


In closing we have many concerns in our current situation.  Some pundits claim that markets are headed higher and that we are under estimating the recovery.  They say that everyone is too worried and that the fundamentals are strong.  We apparently are looking through an entirely different lens.  With the EU continuing to deteriorate we cant help but wonder how investors can look at the rise in LIBOR as anything but bad.  While Greece is indeed a small nation the Euro is what is at stake.  Yes, the same Euro which is probably the biggest economic experiment of the last 30+ years.  In addition to the EU we have “regular” geo-political concerns as well like Iran, the Korea’s, and our future energy supply.  So while we could of course go higher we definitely should be concerned.

Happy Trading,

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The Euro Is Overvalued

One of our major themes here at The Macro Trader over the past two years has been to short Europe. We mean that in a general sense as we have been short Spain and Italy off and on for over a year and are bearish on most things EU relative to most of the world. One area that we have been looking at a lot lately is that of the Euro.

After being overvalued by 40% back in March of 2008 the Euro fell about 20% as investors went into risk aversion mode and bought the US Dollar. Since March of this year the Euro has once again climbed into wildly overvalued territory again and is currently about 35% overvalued. As you can see in the chart below when the Euro gets very far above or below the 20% bands it has a relatively sharp tendency to revert to the mean. (Click on chart twice to enlarge)



Our view is that sometime in the next few months we will have a modest US Dollar rally as investors leave the Euro. In fact this is one of the primary reasons why we think that gold has been working out so well. Basically the EUR, USD, and JPY are all really weak and investors are doing anything possible to diversify out of them.

One tool that we use a lot to gauge our timing in regards to trading currencies via PPP valuations is that of the different volatility indexes. While you can monitor the EVZ Euro VIX, we also look at the JP Morgan G-7 VIX so to help us gauge the risk aversion in other G-7 currencies as well. Right now this is important as there are several currencies overvalued by 20% or more, but that is for another post. Anyways as you can see in the chart below the JP Morgan G-7 VIX is at relatively low levels and is showing little sign that anything is happening yet. (Click on chart twice to enlarge)

JP Morgan G-7 VIX


Happy Trading,

Disclaimer-The Macro Trader is currently not short the EUR/USD but that will change at some point.

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:

Title: The Euro Is Overvalued


Volatility Indexes, Risk Appetite, Mispriced Risk, And Where We Think We Are Headed

If over the past six months or so it has seemed as if you were partying like it was 1999 it might be time to reevaluate your stance.  One thing that we have been taking a closer look at lately is the pricing of risk.  Obviously when investors think that risks are low they will demonstrate risk seeking behavior.  We have seen this as the SP500 has climbed 56.6% from the March lows to the highs on 8/28/09.  With a rise like that you would think that 2008 never happened, of course if you believe that then you also believe  in a land of make believe with money trees, the fountain of youth, and SI models for all of us.

Of course some investors counter saying that while things could be better we are seeing the beginning of a recovery.  They then say that while the market will likely climb slower, that it will still climb higher.

While the above scenario is possible, anything is possible.  The more important question is to decide if the rewards outweigh the risk involved in being long equities right now.  Or even if at this point the better risk reward trade is to the downside.

Lets look at a few “risk gauges” or “fear indexes” as the press likes to call volatility indexes.  The first is of course the VIX.  After spiking to all time highs in October and November of 2008 we are already well on our way towards what was considered a “normal” level back in early 2008 before Bear Stearns.  The potential risks were obviously very mispriced at the beginning of 2008, are they mispriced again?  While likely not as off as they were at the beginning of 2008 we still think that there are a lot more real and potential risks then the market is currently pricing in. (Click on chart to enlarge)



What about foreign markets?  How do investors perceive the potential risks abroad?  Well if the VDAX is any gauge then investors see a rosy future in Europe as well.  Again maybe there are no big risks and maybe the EU is rock solid.  Then again maybe not.  With the complete lack of liquidity that businesses have had over the past several months in the EU it is really surprising that the VDAX is back to pre-crisis levels. (Click on chart to enlarge)

German DAX VIX


What about other asset classes?  What are investors saying about potential risks?  Using the MOVE Index which measures the range in which Treasury yields are expected to move over the next 12-months we can see that even here investors are becoming increasingly complacent.  What happened to the runaway inflation that we keep hearing is right around the corner?  Right now the market is saying that we will be in a 130 basis point range for the next 12-months. In The Macro Trader weekly newsletter we are long the TLT 20+ Year Treasury ETF and are expecting a bigger move then is currently implied via the MOVE index. (Click on chart to enlarge)

MOVE Index


Even in the currency markets we are seeing extreme complacency.  Apparently investors the world over are back to selling dollars in exchange for anything.  While the USD has its issues other currencies do to.  Right now the currency markets are not participating in the Keynes beauty pageant where you are trying to pick the girl that you think the judges will think is the beautiful.  No, with the current state of the global economy we are in the least ugly pig contest where we are only trying to find the least ugly.  That being said investors do not appear to see a lot of volatility any time soon. (Click on chart to enlarge)



Even the emerging market currency volatility index is showing complacency. What happened to the banking issues in Eastern Europe? Apparently they vanished, or at least that is what it seems as though the market is telling us.  (Click on chart to enlarge)

JPM Emerging Market FX VIX


Even commodities markets are pricing in realtively low risk. While the price history of the Crude Oil and Gold volatility indexes does not go back as far as we would like, you can get a feel for what is happening as both indexes are dropping at a very steady rate.  Do investors really think that volatility will stay that low?  What happened to the oil spike if demand comes back?  And what happens if gold breaks $1000 on fears of hyper inflation?  (Click on charts to enlarge)

Crude Oil VIX


Gold VIX


Another excellent tool to evaluate the blind risk taking happening right now in the stock market is the JunkDEX invented by Bill Luby over at VIX and More.  By taking an equal weighting of junk stocks AIG, FNM, C, CIT, and BAC you can see how crazy or composed investors are acting. While we have seen, and actually use, an index of high momentum stocks we had never thought of making an index that tracks junk stocks to gauge investors risk appetite.

As you can see in the chart of the JunkDEX below the junk led the market off the bottom and then lagged until the last month when the index shot up +157.36% in a little over a month.  While it has pulled back over the last two days we are still in awe that investors are dumb enough to buy this junk at these prices. (Click on chart to enlarge)

VIX and More JunkDEX* vs SP500


After looking at all of this we need to ask ourselves if the rewards outweigh the risk to stay long?  Or if we should be flat or short.  In case you have not guessed we currently think that the risk reward is pointing to the downside.

Looking at the QQQQ we have a setup with a solid risk to reward situation. As you can see in the chart below the QQQQ has rallied back to its 50% retracement level, its 200-week moving average, and its downtrend line extending from October 2007.  While it could of course rally higher we like the risk reward enough to have put on a modest short position in our weekly Macro Trader newsletter. (Click on chart to enlarge)



While not quite as nice of a setup as the NASDAQ 100, the SP500 also looks like a solid risk reward trade to the short side.  As you can see in the chart below of the SPY-SP500 ETF it has rallied up to the upper Bollinger Band and has already started to come back in.  We are looking for a move back to at least the $95-96 area. (Click on chart to enlarge)



Obviously anything can happen.  The market could go up every day for the next year, or it could go down every day, but our job as traders is to look for the best risk to reward scenarios that we can find and place trades on probable scenarios and right now we think the most likely scenario is for the market to at least have a pullback if not a correction back towards its 200-day moving average.  Of course if this happens we will see the volatility indexes tick upwards to more realistic levels given our current economic environment.

*Our JunkDEX differs a bit from the one you can see at VIX and More.  After looking into it we found that  we built the index by simulating a $1000 investment in the index and in the SPY and Bill built it by normalizing the index starting value so we have slightly different values.  But don’t worry as the chart looks essentially the same and shows the same investor insanity.

Happy Trading,

Disclaimer-In The Macro Trader newsletter as well as our accounts we are currently short some QQQQ-NASDAQ 100 ETF and long some TLT 20+ Year Treasury ETF.

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: Volatility Indexes, Risk Appetite, Mispriced Risk, And Where We Think We Are Headed

The Carry Trade and Volatility

In our ETF based newsletter, the carry trade is one of the strategies that we employ. For those unfamiliar with the carry trade, you are essentially trading the interest rate differentials of different countries. You short a low-yielding currency and go long a higher-yielding currency.

You can make money in two ways. You earn the “carry” if the currencies remain very stable, and neither move. You can also make money in this trade by being correct in the direction. For instance if you are short the Japanese Yen and long the Australian dollar, then you can also make money if the Australian dollar goes up, and the Yen goes down.

As an example of how to earn the carry, lets look at the Japanese Yen versus the Australian Dollar. The Yen has been the carry trade vehicle of choice for much of the past decade because Japan has consistently had extremely low interest rates. Australia, on the other hand, has had relatively high rates over the last decade.

To construct the differential for this trade, take one rate and subtract the other rate. In the chart below, we plot the difference between the AUD and the Yen since the beginning of 2007. As you can see, at one point the carry was as high as 7.34, but it has since declined to 2.69. If you had been long the AUD and short the Yen, you would have earned this interest rate differential the whole time.

AUD-JPY Interest Rate Differential

AUD-JPY Interest Rate Differential

Of course as we already mentioned, in order to make money on the carry trade, your long must outperform or stay flat relative to your short position in order to make money since a big directional move against you will wipe away any gains that you would be making solely off the carry.

There have been several academic studies as well as real world trading results that show that volatility is the biggest risk that the carry trade faces. Over the years, most studies were stuck using the SP500 VIX as a proxy for global financial market volatility. While it correlates quite well, there are now some far better options to help track and manage risk in the currency markets. We at The Macro Trader use the JP Morgan G-7 VIX index for our carry trading model as it correlates extremely well to the volatility in the DBV-Currency Harvest Trust ETF.

What we first found in the academic literature, later confirmed by our own testing and used successfully in our trading, was that when volatility in the currency markets is flat or declining, the carry trade works very well. On the other hand, when currency volatility is high, the carry trade typically is a money loser because the directional aspect of the trade overwhelms the carry, giving you a loss.

We look at the JP Morgan G-7 VIX using two different charts. The first one is a reversion to the mean chart where plot the VIX data, the historic mean, then one and two standard deviations above and below the mean. When volatility is high and then falls below one standard deviation, we start looking to enter the carry trade and when it get above the one standard deviation line we would sell if not already stopped out. On the downside, we look to sell when volatility declines too much since it represents excessive complacency and usually is a sign of higher volatility ahead.

JP Morgan G-7 VIX


The other way that we like to look at the currency VIX is to invert it on a chart alongside the DBV. As you can see in the below chart, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it was able to break out to the upside.



Finally we have the DBV itself. As you can see in the chart below, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average. Finally today it broke out to the upside.

DBV-Carry Trade ETF


Hopefully you see how volatility is bad for a lazy trade like the carry trade where you trying to get paid for sitting. If volatility climbs above 1 standard deviation above its mean we will look to tighten our stops as the odds of a downside move increase significantly.

DBV-G-10 Currency Harvest Fund is an ETF that goes long the three highest yielding currencies of the G-10 and shorts the three lowest yielding currencies on a 2x levered basis. While investors can go into the spot and futures FX markets and put on the same trade the DBV is a very simple way to gain exposure to positive carry in the currency markets.

Happy Trading,

Disclaimer-We currently hold positions in the DBV-G10 Currency Harvest Fund and FXA-Australian Dollar ETF.

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Title: The Carry Trade And Volatility