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Stepping Into An Empty Elevator Shaft at Trader’s Narrative

Boy that was an exciting day! I recall pining for some volatility last month (from the April 2nd 2010 Sentiment Overview):

Would someone please go over and poke the VIX to see if it is still breathing? I know that low volatility is not necessarily a sign of a market top but also consider that contraction leads to expansion in the market. So don’t let this lethargic interlude lull you into apathy.

That’s the way the market works. If you so much as underestimate it for one day, it rips your face off just to remind you who’s boss. Here are some random thoughts on this fascinating day in the markets:

Volatility Enter Stage Left
I think by all accounts we can categorize this as a mini-crash. It felt like stepping into an empty elevator shaft. The CBOE volatility index spiked to a high of 40.71 intra-day but closed at 32.80. From the intra-day low last month to this intra-day high, the VIX has jumped higher by more than 167%. This means that it closed 68% above its 50 day moving average. The last time it did so was in the tumultuous markets of October 2008 when the credit crisis had everyone running around panicking. And when the VIX was trading around double where it is now.

What Me Worry?
The options markets were surprisingly sanguine about the whole ordeal. Intra-day, the equity only ISE Sentiment index dropped to just 119 at 2:10 PM and 123 at 2:30 PM. And again 123 at 2:50 PM when the worst was over. It finally ended the day at 136 (which is equivalent to 0.735 expressed in put call ratio format). I was expecting to see at least one intra-day interval where the ISE had fallen below 100 - that is where we would see more puts being bought than calls.

Similarly, the CBOE put call ratio (equity only) dropped to 0.68 at 2:00 PM and held that level at 2:30 PM. At 3:00 PM it was 0.67 - again very subdued considering everything. It ended the day at 0.71 (141 expressed as call put ratio). So both confirm that option traders were nonchalant about the mini-crash. Or very complacent.

Bond Yields… Fall?
You may recall that Ned Davis Research was “maximum overweight equities” and was nervously monitoring the long term government US bond yields as a tell for weakness in the equity market. But as a result of the flight to safety, we are seeing the opposite occur as 30 year bond yields collapsed today to 4.165% from their peak at 4.858% in early April. There was also a flight to another bond market but more on that below.

Bye-Bye or Buy?
I recently showed a method of using the percentage of stocks above their moving averages to pinpoint buy opportunities. The percentage of S&P 500 stocks above their 50 day moving average is 27.6% - at February’s low it was 17.8%. The percentage of S&P 500 stocks above their 150 day moving average is 65% - at February’s low it was 60.2%

Their ratio is, as of today’s close, 0.42 - this suggests that we should be on the lookout for buy opportunities, not further weakness. This ratio can go lower, but during healthy bull markets it rarely does.

As well, the S&P 500 closed 3.6% below its 50 day moving average. If we are still in a healthy bull market, then this is similar to previous times it fell to this level: early February 2010 and early July 2009.

Another metric that suggests that we’ve come far enough is the ratio of new 52-week highs to new 52-week lows (for the Nasdaq). As you can see from the chart below, during this cyclical bull market, it has been a faithful guide. This ratio found the inflection points in early July 2009, late October/early November 2009, and early Feb 2010.

Click to see larger chart in a new tab:
nasdaq new high low ratio May 2010

That’s all dandy but what the heck caused this in the first place?

The Greeks On the Grassy Knoll
Many are pointing the finger to the riots in Greece. The takeaway is that the Greek people will not tolerate any belt-tightening and will vote in a government which will remove austerity measures. The 10 year Greek bond which we looked at as a tell for the US equity market, closed at 11.31%. There is also a major concern for contagion as Spain’s 10year government bond yield also jump higher with its spread the highest since 1999 at the formation of the EU.

Clearly something went very wrong with the trading in Proctor & Gamble (PG). It isn’t clear exactly what happened but it was probably not trades which went through at the NYSE but an ECN or a darkpool. But there were many strange prints. For example, round the same time, 2:48 PM, Accenture (ACN) had a print which took it down $0.01. Not surprisingly Nasdaq announced that they will bust trades made between 2:40 PM to 3 PM where the price varied by more than 60% from the last trade at 2:40 PM.

The Best Explanation
The best explanation I can offer is that the dominoes fell in this order: capital is fleeing Europe because of default risk. This capital is finding safe haven in Japanese bonds which have the least risk of interest rate hikes. This skewed the US Dollar/Japanese yen currency exchange rate. This then influenced the carry trade, which has such a gargantuan amount of money riding on it that any move is amplified to an unbelievable degree.

So all the carry traders see the shift in the Yen and they automatically issue a massive amount of algorithmic selling in US markets and/or a fat-finger trade by a very anxious trader wanting to get out as quickly as possible. As evidence, take a look at the intra-day chart of the two markets. The blue candlesticks are the S&P 500 index (SPX) and the white candlesticks are the US dollar/Japanese Yen exchange rate.

Click to see larger chart in a new tab:
JPY USD carry trade mini crash May 2010

It isn’t easy to see, unless you regularly trade the Yen, but the move in the Yen is massive and many times the average normal range. Pull up a daily chart of the Yen and you’ll see what I mean. I would be looking to lean the other way into the Yen, Japanese bonds, US bonds and equities (for a very quick trade).

If you have a better explanation, let’s hear it. But for heaven’s sake! please don’t bring up the PPT or any of that nonsense.

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3 Responses to “Stepping Into An Empty Elevator Shaft”  

  1. 1 Ahmed

    I must say I am very impressed with your analysis. You provided the best explanation to yesterdays mini-crash. Thanks for sharing your insights.

  2. 2 InEgoVeritas

    Umm usually these carry traders (and other Japanese funds invested in the US) would just hedge their yen exposure by selling usdjpy in times of trouble. They wouldn’t have to sell their EQs positions for that.
    This would explain the sharp sell off in usdjpy… but i wouldn’t go as far as to say that they caused the massive US market sell off.

  3. 3 thunderbird

    As above, thanks for your explanation re: JPY carry trade. That really is an incredibly insightful explanation, and I hope in the coming days we see some discussion of this in the broader media.

    Do you feel able to draw some conclusions from your explanation, though? I.e., if there is capital flight out of Europe (and there certainly was out of Greece over a month ago), what will happen next?

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