Ever Dance with the Devil in the Pale Moon Light? Feedback loops, China, commodities, and VAR models.
The Joker: Tell me something, my friend. You ever dance with the devil in the pale moonlight?
Bruce Wayne: What?
The Joker: I always ask that of all my prey. I just... like the sound of it.
This post marks the return of Miller’s Market Musings, a free weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. For the past three years these posts were written exclusively for clients of my prior employer (understandable, they were paying for them), but now that I am back at my own firm, I am free to distribute these notes once again to the public. You can subscribe here. If you no longer wish to receive this letter, simply hit reply and put “Remove” in the subject line. Prior posts (from pre-2012 can be found at www.millersmusings.com). Now on to the good stuff…
In case you were out, stock markets around the world took a bit of a dive this week. In particular, the S&P 500, which had been stuck in an incredibly narrow trading range going back to February of this year, fell about 6% this week. There have been lots of pundits offering reasons for the selloff. These generally include the mini-crash going on in Chinese stocks, the mega-crash going on in commodities, and the prospect of interest rates rising here in the U.S. So which of these things caused the 6% fall in the S&P 500, and an even bigger fall in the NASDAQ 100? In particular, which caused today’s over 3% decline? None of them. At least, not on their own. What caused today’s decline was feedback loops, emerging markets and VAR models.
Volatility had been low – until it wasn’t. One-year chart of the SPY: (source: Interactive Brokers, LLC).
Think about it – what is new this week that wasn’t already fairly obvious to those paying attention? China has been slowing for a long time. Today’s data showing that its export-oriented small and mid-sized companies are seeing weakening prospects, while slightly worse than expected (Caixin China manufacturing PMI came in at 47.1 versus 48.2 consensus), wasn’t really unexpected. Japan and Europe actually posted better than expected PMIs today (but no one really mentioned that). But what the slowing does do is reinforce the fact that the world is over-supplied with commodities. Back when China was booming (you know, just a few years ago), it was absorbing huge quantities of raw materials. So supply was ramped up to meet that demand. Copper, oil, steel, coking coal – the need for these seemed insatiable. But today, as China’s economy slows, demand for these has declined dramatically. Companies that have a large China presence have been leading the decline in the U.S. in the past week (along with media companies for a completely unrelated reason).
Here is where the feedback loops come in. Emerging markets are generally commodity producers, either of raw materials or of goods that are so easily replicated that they are essentially commodities (think t-shirts, socks, or even basic memory chips). As demand goes down, so do their exports, so some central banks cut interest rates, hoping to weaken their currency to make their goods cheaper on the world markets. So their competitors do the same in a race to the bottom (which no one really ever wins). Now, combine this with expectations that the Fed is going to start raising rates sometime soon (maybe September, maybe December, but rate hikes are coming is the consensus). This, along with the fact that the Eurozone is a mess, has made for a very strong Dollar relative to almost every currency in the world this year.
But…here is what the central bankers usually forget. A little depreciation is ok. A lot is not, because rarely is a country able to supply all its basic needs internally. It imports things. Like food. Or oil. Which just got more expensive. So as people shift a higher percentage of their already meager earnings into food and energy, their ability to buy other things goes down, driving down their economy. So their central bank cuts rates. And so on. Eventually, foreign investors in their markets do some math and realize that while they would love to have exposure to their long-term growth, if the emerging market currency declines more than the return on their investments versus their home currency, they just lost money. So they sell to cut their losses and take their money out, causing a further decline in the emerging market’s stocks and currency.
Batman: I’m just going to hang around the bar. I don’t want to look conspicuous. Batman, 1966
Here is where the Value-at-Risk, or VAR models, and leverage come into play. Big global investment funds are, generally, managed from the U.S. or Europe and denominated in dollars or Euros. As the U.S.-based funds have seen their foreign investment returns diminished by the strong U.S. dollar and/or falling foreign markets, they have had to sell other assets to keep their leverage within their prescribed limits. If your leverage limit is a standard Reg T 2 to 1, and your emerging markets book drops 15% in dollar terms, and you were say 25% in emerging markets, you’re now levered 2.16 to 1. You need to sell that extra 0.16, or 16% of your underlying assets, just to get back into line. But if you were using higher leverage, say 4 to 1, and 25% of your book drops 15%, now you’re levered 4.7 to 1. Not good. That 0.7 needs to go, and needs to go now. But here is the kicker: you’re no longer allowed to be levered 4 to 1. Because volatility has gone up, which is the input into your prime brokers VAR model. When volatility is low (look at the last 6 months of the SPY above), VAR models allow you to lever more. And lots of macro and quant funds like to leverage up, especially if they are running low net exposures. When volatility is high, these models let you leverage less. And the inputs these models use are short-term – the volatility spike this past week has made highly-levered funds look very conspicuous to their margin departments. Volatility in China’s market spills into volatility in Thailand and Vietnam and other emerging markets, which feeds into VAR models and creates the sell-off you see happening now in U.S. markets.
Penguin (organizing his election): Plenty of girls and bands and slogans and lots of hoopla, but remember, no politics. Issues confuse people. Batman, 1966
Unfortunately, China has made their stock market into a political problem, and markets don’t like politics. After the circus that was Greece and its dance with its “partners” in the Eurozone, U.S. investors were looking forward to a quieter August and maybe some time at the beach. But China has badly mismanaged its stock market, and has turned what should be an isolated issue into one that has spillover effects for us, mainly because China has become uninvestable. Issues confuse people. And confused people sell.
Right now we are maintaining our zero-net exposure. Being conservative and coming into the month with nearly 50% cash has worked so far. We are going to see how China trades Sunday night and how our markets open Monday. I expect our markets will be ugly unless China and emerging markets are up at least 5%. We closed right on our lows on Friday, which in my experience is never a good sign. It means buyers are still scarce, and they probably should be. Despite the drama this week, the S&P is only off a bit over 6%. Compared to the declines I’ve traded in 1994, 1997, 1998 (August then was a good time – the XLF dropped 20%, driven by deleveraging), 2000, 2007, 2008, 2009, 2011 – this is nothing. This sell-off will give us our opportunity to buy and hold some quality companies. We’ve been picking away at our favorites this week. (Want to know what they are? Email me for a free trial of my StockPicker newsletter). In the meantime, dance with the devil if you must, but be very careful. Because, you know, issues confuse people.
Trading Rules: The Trading Rules were always popular, so they are back. This week’s:
Support: 197/197.50, 192.50/193, then 182.
Resistance: 204.5/205, 208, then 212/213.
Positions: Long and short U.S. stocks, long SPY puts, long SPY calls.
Miller’s Market Musings is a free weekly financial market e-letter written by investment manager Jeffrey Miller. Mr. Miller has been quoted in financial publications including the Wall Street Journal and New York Times, and he has appeared on Fox Business News, PBS and CNBC. More information and past articles can be found at www.StockResearch.net. Sharing and quoting from this letter is permitted.