One of These Things is Not Like the OtherJune 3, 2011
In just the past week, the market has had to deal with bloodshed and revolution in Libya, Iran warships in the Suez Canal, Oil prices above $100/barrel and protests over an almost bankrupt State of Wisconsin. Individually these are potentially market moving events. Taken together they are sending stock prices lower, hitting the markets during a particularly vulnerable period when few investors were prepared for volatility. Headlines of course are not predictable, but investor reaction to headlines is like clockwork. Strong stock market performance over the past several months has given investors that nauseous feeling that they are missing out. From hedge funds to retirees, risk appetite has returned to dangerous levels. Here are some examples.
Current VIX levels have corresponded with short and intermediate term market tops over the past several years.
Margin Debt Near Dangerous Levels
The January NYSE Margin Debt report is showing total portfolio borrowing hit a peak of $290 billion, and that available free credit has dropped to levels not seen since the credit bubble peak in July of 2007. Not only are both institutions and private investors buying with both fists, they have maxed out portfolio credit to do so, creating leverage not seen in years.
Regarding the January NYSE Margin Debt report ZeroHedge comments:
“At ($45.9 billion) this number is just below the ($52.8) billion last seen just before the August 2007 quant wipe out which blew up Goldman’s quant desk, and arguably was the catalyst for the beginning of the end. In other words, as we have shown, everyone is now purchasing on margin and the level of investor net worth is the lowest in over 3 years. Which means that should the market decline from this week persist and the Fed be unable to stop it, the margin calls will start coming in fast and furious, and unwinds in otherwise stable products like gold and silver are increasingly possible as hedge funds proceed to outright liquidations.”
High Yield Bond Yields Near All Time Low
>High Yield Bonds often serve as a leading indicator to the markets. The effective yield on the Merrill Lynch High Yield Bond Index is now near levels where major price declines have occurred in the past. This is a stark contrast to just 24 months ago when yields hit record highs during the apex of the credit crisis. High Yield bond yields are now at 7.1%, just 0.02% above their all-time lows, even though High Yield bond spreads, now at 529bp, are 266bp above their record tight level from 2007.
Opportunities Increasing for Absolute Return and Long/Short Strategies
The combination of low VIX levels and highly leveraged portfolios is a dangerous combination, and usually leads to swift declines as investors are left with little protection against falling prices. Add in historically low High Yield Bond yields, and you have a market climate that is ripe for headline risk.
It has been 10 months since the S&P 500 has suffered anything more than a 3.5% decline. For buy and hold, and asset allocation investors without a dynamic risk management strategy, now may not be the ideal time to deploy new capital to passive investments. Investment strategies that favor both long and short trading and the ability to benefit from short term volatility, the environment should be ripe for opportunity. It is in these market climates that Anchor Capital strategies have outperformed in the past.