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Looking For Reasons In All The Wrong Places

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Examining how credit markets continue to drive risk sentiment.

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I cannot recall a more virulent period of Twitter-hate toward equity markets ripping higher, or toward anyone suggesting that the rise in stocks makes sense.  The persistent mantra is that i) earnings and the economy cannot explain stocks trading at current levels; ii) euphoria is sky-high; and iii) traders are oblivious to the clear-and-present dangers that will inevitably send us back into a 2008-2009 style panic.

I happen to to agree that few fundamentals justify the recent behavior of stocks, but, as intellectually annoying as it may be, none of that has much to do with stock prices.  Rather, when viewed through the lenses of the corporate bond market and credit derivatives (Credit Default Swaps), I submit to you that the recent drop and pop in equities makes perfect sense.  I explained all of this in some detail in an article back in February of this year.  I'm summarizing it below, but I urge to read the article if you are interested in the mechanics of a "bear raid" and the subsequent recovery.

• Arguing that "stocks must rise/fall because of fundamentals, the economy, QE, foreign markets, China, the EU, Draghi, etc." is tantamount to beating one's head against the wall; that relationship broke down a decade ago;

• Stocks have been, and continue to rise on "financial engineering", "manipulation" or whatever other disparaging attribute you want to use to describe "borrowing money to buy back stock";

•  The frequent short-but-violent stock drops depend on macro credit players attacking the CDS  market in an effort to disrupt the corporate bond market. In the period immediately after a raid by credit-bears, stocks go higher because of short covering in the credit/equity markets.  Longer term stocks go higher based in large part on the ability of companies to access the corporate bond market to buy back stocks. 

• As long as the corporate bond market remains open despite disruptions to credit derivatives, odds remain overwhelmingly in favor of those who buy-to-sell rather than sell-to-buy, because being long CDS will not work if the underlying bonds do not buckle;

• The bulk of the evidence is that the corporate bond market remains in as good a shape as ever:

i) issuance remains on pace to exceed last year's $1.5 trillion tally;
ii)  spreads are within 92bps of this summer's post crisis lows, and 410bps below the 2011 highs;
iii) recently issued bonds - except for energy companies - are trading exceedingly well;


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iv) credit hedge funds are still relatively under-leveraged (anecdotally 8-10x vs. '07-'08 peaks of 40x plus);
v) even if these funds were highly leveraged already, based on the FINRA High Yield Total Return Index, virtually all HY buyers since the '09 bottom are comfortably in the money, so the likelihood of margin calls on credit funds is slim to none;


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vi) M&A/LBO's are getting financed at will; and
vii) the rate of fresh money being allocated to credit and commercial real estate by pensions and other large credit buyers is increasing at an accelerating rate.

• Yes, when the flow of money into credit funds ends and the above dynamic breaks down, the subsequent credit crisis will make '08-'09 feel like a walk in the park;

With that in mind, let's fast forward to what has been happening lately.  The chart below shows the Markit Series 22 Investment Grade CDX and the S&P 500 (SPX).


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For visual ease I have inverted the scale of the SPX to show how tight the correlation (causality?) really is between the action in CDS and equities.  And to get even more granular, a sharp quant-tweep actually bothered to calculate that every 1 basis-point move tighter or wider in the IG CDX equals about plus-or-minus 10 SPX points. 

Furthermore, if the CDX/equities relationship were not enough to explain what has happened in the last few weeks, let me offer you a couple more data points that have added fuel to the fire.  First, despite the vertical move in stocks and the protestations that all shorts must be wiped out by now, total NYSE short interest closed the month at the 2nd highest level since March of 2009.  Bears are far from extinct.


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Second, considering the 10% move by the SPX in less than 3 trading weeks, Friday's close of +2.77 in the 3 month curve of the Volatility Index (VIX) shows that the curve remains rather flat.  As I explained here, this is a strong tell that stock players are everything but complacent.  A sustained period above +3 would suggest complacency, and euphoria doesn't kick in until +4.

In summary, there are very valid reasons for the move higher in stocks, they just happened to be NOT the reasons fundamentals-driven investors want to hear, or can agree with.  On Tuesday I suggested that for stocks to continue to ramp higher, credit would have to put in another leg of tightening. That materialized on Friday.  Purely from an equity standpoint stocks are now overbought but, as long as credit holds its gains, oscillators are likely to come back into balance more through time (sideways action) than another sharp, prolonged and scary pullback.  I did make some sales on Friday but mostly in the form of covered calls against SPX and SPX futures long positions.

Twitter: @FZucchi

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No positions in stocks mentioned.
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