The markets will chop sideways forever, I wrote early in January.

 

Above: Bank of America Option Implied Volatility (from ivolatility.com)

 

Volatility has collapsed back to pre-Lehman levels. Starting on April 27 I began warning of a volatility implosion, which now has run its course.

Too many things can go wrong at this point.

1) The real estate rally is aborting, judging by the price of structured product. The Markit Indices for commercial mortgage backed securities (CMBS) are a pretty good indication of loss expectations. The single-A tranche is interesting, because it carries 15%-20% of loss protection, and in turn protects the AAA and AA tranches. It is something of a levered bet on survival of cash flows. It had a big rally a few weeks ago followed by a recent letdown:

SIngle A Tranches of Commercial Mortgage Backed Securities Indices (Markit)

The same pattern applies to structured securities backed by subprime mortgages and other consumer assets. The one area in which prices have been robust is in collateralized loan obligations backed by high-yield loans. That’s a small and relatively technical market.

All this suggests that there simply isn’t any real improvement at the base of the economy. Mortgage rates have backed up along with the Treasury market and the Federal Reserve clearly is unwilling to buy mortgages indefinitely to support the market. The market for inflation hedges showed the Fed the instruments of torture. Along with asset prices, the bank rally has fizzled. Banks are doing nothing and have nowhere to go, which is why the implied volatility on bank options has fallen so far.

It is interesting that the commodity rally has stalled out: the rise in bond yields (and the very premature anticipation of an eventual Fed rate hike) sent a chill whiff of deflation back across the markets. The markets appear stalled, with nowhere to go.

That can’t be good.

In the long term, I expect Asian equities to outperform American equities, but the long term can be very long indeed: governance in Asia remains extremely uncertain. Nonetheless I am very slowly and carefully buying Asian equities, looking for individual names that have the potential to become great international companies (or great international companies now trading too cheaply). I also am looking for long-term commodity plays, with an emphasis on agriculture.

Still, I expect that the next move in markets will be down. The Obama adminstration’s “sugar high” (as Robert Zoellick characterized it) surely is not doing much for the consumer. US households paid down nearly $30 billion of consumer credit during April and May, an unprecedented reversion to savings. To finance a $1.8 trillion deficit without monetizing Treasury debt, the US can import (maybe) about $300 billion a year in capital to the Treasury market (all time high was $400 billion and there is pushback from the Chinese and others). It needs about $1.5 trillion in domestic purchases, or about 10% of GDP. That’s a pretty high savings rate, and it presumes that NOTHING gets financed apart from the Treasury deficit. The Fed, to be sure, can monetize a few hundred billion of Treasuries or mortgages, but not much more — the markets have already caught on to the sleight-of-hand.

I haven’t changed my view since the beginning January: the stock market will chop sideways forever.

I’ve been a big advocate of the credit rally all year — that’s a falling-volatility play, of course — but I am taking profits in some of my credit portfolio.

This entry was posted on Tuesday, June 9th, 2009 at 7:20 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.