The Summer Crash of 2011 and the Shape of Things to Come
by: Michael A. Gayed
August 5, 2011
“The best thing about the future is that it comes one day at a time.”
- Abraham Lincoln
On June 8th I published an article here on SeekingAlpha titled The Summer Crash of 2011, Or the Great Re-Adjustment. In it, I argued (without the benefit of hindsight) that markets were primed for a a significant decline based on various inter-market relationships I closely follow. It has been a long few months, but the scenario I laid out in that article and in many subsequent articles appears to be playing out.
It's nice to get a major event right, but even nicer to be positioned properly for it. I don't know of any investment firms that were calling for this decline, let alone any that positioned into bonds for it the way we did for our clients based on our quant models.
The question, of course, is where do we go from here. Is the Summer Crash over, or are we just getting started in what could be the start of a full-blown bear market? Before I get into my usual relative price ratio analysis, consider this. The VIX index (spot, not 1 month futures as proxied by the ETN VXX), which effectively measures the cost of insurance on big drops in the S&P 500,is just barely below 30.
Given the possibility of a Eurozone collapse, Lehman-like scenario, and fragile state of all risk assets (particularly Junk Debt), I personally believe the VIX should be considerably higher than where it is now despite yesterday's big run up. If anything, the fact that the VIX isn't higher despite clear and present risks to the global economy probably means investors in equities are completely underestimating the possibility of a much further declines to come.
Speaking of Junk Debt, let's take a look at what credit spreads are doing. Take a look below at the price ratio of Junk Debt (JNK) relative to 10-Year Treasuries (IEF). As a reminder, a rising price ratio means the numerator/JNK is outperforming (up more/down less) the denominator/IEF.
The spread has collapsed in recent days. This is an absolutely significant event. The fact that the ratio broke down with such force, and is now lower than the June 16th level (which was when I originally felt we were on the verge of a breakdown) means that this is no longer an equity correction, but a credit event. What the above ratio trend means is that Junk Debt yields are rising while Treasuries are falling, causing a huge widening within the bond market between high quality and low quality obligations.
Clearly this is not a good situation for anything risk-related. Take a look now at the price ratio of longer duration Treasuries (TLT) and the S&P 500 (IVV).
As I have been saying since June 8th, the ratio needed to spike given that absolute bond yields were so low and that the ratio was was still depressed. I've been calling for this ratio to get to 1, which would happen through a combination of lower bond yields (TLT going up), and the S&P 500 going lower (the denominator shrinking). However, I am now starting to wonder if we may blow past that. The steepness of the rally in the past week in the price ratio is reminiscent of how the ratio behaved at the far left of the chart – when Lehman crashed.
Where do we go from here? The only thing for certain is that volatility continues, but given continued complacency, inter-market relationships, and quite honestly every news anchor in the world asking whether investors should BUY and not SELL, I don't believe the mentality has shifted to the possibility of something spectacular to come.
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