E-piphany

It wasn’t the slowest day of the year so far, but that is only because of the extraordinarily weak start we have had to the year in terms of market volumes. I will have a little more to say about that, later, but for comparison today’s volume was lower than any day in the first three full weeks of December!

I thought, and I gather that others thought, that today might have been more interesting. The Greek PSI talks, which were supposed to be finished on Friday, were suspended temporarily and, while they have now resumed they have apparently done so with lines drawn in the sand. There is no way to construe the current state of that discussion in a positive way – even if agreement is ultimately reached, it probably is the last such agreement and it isn’t going to be enough anyway.

Those talks were supposed to be done before a meeting of EU ministers today, at which Germany suggested combining the ESM and the EFSF or letting them both operate at the same time. Until now, the plan has been for ESM to replace the EFSF; if both are kept open then it means the new guarantees associated with the ESM become additive to those guarantees still “untapped” in the EFSF, rather than replacing them. It’s not clear to me why other nations contributing to the ESM, who were told the ESM was a replacement for EFSF, would go along automatically with what amounts to an additional coerced contribution, but it’s today’s ‘happy thought’ from the Euro politicians.

The EU over the weekend also determined that indeed there will be an embargo of Iranian oil – they have heretofore dithered – starting in the summer. This helped energy markets, and commodities rallied again, with the DJ-UBS index up 1.62% as the dollar fell 0.5%. Natural Gas spiked more than 10% as Chesapeake Energy (the second-largest domestic producer of nat gas) said it will “cut output, idle drilling rigs and reduce spending in gas fields by 70 percent” according to Bloomberg. The combination of less supply and more demand if there is shifting away from oil at least among dual-source consumers turned out to be helpful for gas.

The stock market ended the day nearly unchanged after trying both a rally and a selloff and deciding that neither direction provoked activity from investors. Treasuries sagged again, with the 10-year up to 2.06% and near the highest yields since October. I think there is more coming to that selloff, but we might some modest support near this level. 10-year real yields are also at their highest levels in a while, back up to 0% although 13bps of that is the roll to the new TIPS issue (that is, the old guy is at -0.13%). TIPS yields also I expect to rise, although less so than for nominal bonds. Breakeven inflation remains quite inexpensive.

The VIX has fallen all the way back down to 18.7, a level it hasn’t been at since July. It is very hard to maintain options implied volatilities if the actual payoff to delta-hedging is virtually nil, and that’s partly what is happening. At these levels, it starts to make sense again to add equity exposure through options rather than through outright positions.

I didn’t say whether the position I would take here is a bullish one or a bearish one. I continue to be modestly optimistic that the economy can avoid a recession as long as Europe doesn’t implode; the problem is that is still looking quite likely. And equity prices are high, measured in reasonable ways, even if you don’t assume that margins will return to long-run means.

However, it occurs to me that one way to look at the current volume lull – an admittedly rose-colored glasses view, but perhaps not indefensible – is that this could represent the first stage of revulsion/exhaustion among investors. After more than a decade of putrid returns and plenty of volatility, it would not be surprising to see America’s love affair with the stock market finally tarnish. Frankly, it’s something that many long-term bears have been expecting for years. (I can’t claim credit for being one of those who declared that investors need to hate equities before we can have a long-term rally. But I thought they needed to stop loving the market irrespective of price.) For me, the connection with price is still important: loathing would be nice, but loathing ought to be accompanied by cheap prices before the low-risk “high margin of safety” opportunities are legion. I don’t think we’re there yet, so I don’t think the current rally is the beginning of a long-term upswing. But the next big selloff we get – say, at least 20% – might produce the revulsion that keeps markets down for a while, and sows the seeds of great opportunity.

As I say, that’s an optimistic view of the awful volumes so far this year. The more-pessimistic view is that this is a natural result of the legislative and regulatory assault on market makers. Darrell Duffie took this view in a recent paper called “Market Making Under the Proposed Volcker Rule,” in which he says:

The Agencies’ proposed implementation of the Volcker Rule would reduce the quality and capacity of market making services that banks provide to U.S. investors. Investors and issuers of securities would find it more costly to borrow, raise capital, invest, hedge risks, and obtain liquidity for their existing positions. Eventually, non-bank providers of market-making services would fill some or all of the lost market making capacity, but with an unpredictable and potentially adverse impact on the safety and soundness of the financial system. These near-term and longer-run impacts should be considered carefully in the Agencies’ cost-benefit analysis of their final proposed rule.

It is a very good paper, and worth reading in its entirety. I admit bias in that Duffie discusses the subject and reaches conclusions similar to those conclusions I jumped to initially (see for example my comments on the Volcker Rule proposals in May 2010 and September 2010), but he applies more thorough reasoning and more rigor. I doubt very much it will matter, since I suspect most Members of Congress can’t read.

And maybe Congressional revulsion is part of the process as well. Lower prices are a reward to long-term investors to provide liquidity when short-term buyers and market-makers are reluctant to – so perhaps this is all part of the process. The bad news is that I don’t think the process is complete yet, but at least it has (perhaps) started.