Guest post by Peter Tchir.
Mind Boggling Performance in Spanish and Italian Bonds
Spanish 2 year yields are at 3.39%, or 50 bps better on the day. There is ZERO liquidity, but even then it is almost unbelievable that on July 24th, these bonds were yielding 6.77%. That is a massive change. It is completely dependent on Draghi supporting them. Without clear indications that Spain will ask for help and the ECB will provide the help, this won’t last. But so far, all indications are that Europe has had a change of heart. Even in Germany, the dissent, while still there, is coming more and more from second and third tier players, rather than key figures.
Even the 5 year point is interesting. Italy and Ireland (yes Ireland is back) have stopped gapping tighter, but are grinding away and now yield 4.87% and 5.50% respectively. Spain remains a star with the yield down to 5.39% which is 36 bps better on the day, and Portugal, of all places, is now yielding “only” 9.4%.
Outright shorts ARE getting killed. Whether you are short bonds or CDS the pain is palpable. The “smart trade” which was allegedly to play the curve from a flattener is also getting crushed as the rally is definitely steepening the curves.
Legend tells of one such lunch at which Heming- way was present along with several writers of the day during which a discussion on the skill of concise story-writing evolved to the point that a wager was made. Hemingway bet $10 of his own against each $10 stake of his companions that he could write a six-word-long short story. six words that would contain a beginning, a middle and an end. the wager was duly accepted by all and one of the more junior members dispatched to fetch drinks for the bon vivants gathered at the Round table. Hemingway took a napkin and scribbled six words upon it which he then presented to the group. It read simply:
“For sale: Baby shoes. Never worn.”
Wager won. Brilliantly.
I was reminded of this tale a few days ago as I listened to the words of Mario Draghi and the immense amount of speculation surrounding his incendiary words last week at a nondescript event in London. Draghi was making unpre- pared remarks—which is always dangerous in a position such as his—and yet markets, bereft of optimism, ripped the words from his lips and clutched them feverishly to their collective bo- som in the hope that this, finally, was the water- shed Europe had been waiting for.
With the markets in bull mood over the past week, accompanied with crazy Algos, many investors are feeling rather confused. The Euromess is still in play, but with major players, except the algos, we are not expecting a break out either way that will last for long. Here is latest by Hussman of Hussman funds.
I’ve never been very popular in late-stage bull markets. Defending against major losses and achieving our investment objectives over the complete bull-bear market cycle (bull-peak to bull-peak, or bear-trough to bear-trough) requires us to maintain an investment exposure that is essentially proportional to the expected return/risk ratio that is associated with each given set of market conditions. When prevailing market conditions are associated with a sharply negative expected return/risk ratio, as they are at present, and either trend-following measures are negative or several hostile indicator syndromes are in place (what we call Aunt Minnies), we will typically be fully-hedged, and will raise the strike prices of our put options toward the level of the market, in order to defend against steep market losses and indiscriminate selling. At present, we expect an average 10-year total return on the S&P 500 of about 4.7% annually in nominal terms, on the basis of rich normalized valuations. Based on a much broader ensemble of evidence, and considering horizons between 2-weeks and 18-months, we estimate the prospective return/risk ratio of the S&P 500 to be in the most negative 0.6% of all historical observations.