Today saw yet another day when the much-expected dip-buyers failed to appear as equities underperformed credit even as both markets dropped significantly. As a measure of the relative selling pressure in equities today, the chart above shows that we saw a very notable underperformance relative to our risk basket expectations.
Further macro disappointment combined with the anticipated approach of an endgame in Europe, the disappointing post release performance of Pandora’s IPO combined with high beta selling and Energy and Materials weakness was further sign of concern.
We can’t help but feel some schadenfreude as we note financials (equities and credit) continuing to slide and we hope the advice over the past month has proved profitable. Rather than be greedy, we strongly suggest taking some profits – at least half for now – off on our very profitable HYG-LQD decompression trade (almost 10% since mid-May inception) which is closing just shy of our target of $44.
While stock indices handily outperformed credit (and risk assets in general) today on a close-to-close basis (for the second day-in-a-row), the tension in the credit markets is rising as weakness in low beta credits, gaps in high-yield credits, bond’s performance relative to CDS, and credit performance relative to stocks all confirm fears are growing.
The chart above shows that equity and spread markets tended to move generally in sync today – which is relatively normal by the way, it is the goings-on among the index components and the context that is very different as HY ended the day marginally wider (though as we discuss below, major changes in internals intrday), IG very marginally tighter, even though stocks managed an almost 1% gain – admittedly on one of the lowest volume days of the year (and on the day when stock futures roll).
On a day that seemed to bounce from one comical European leader’s statement to another amid lower than average volume and little headline-making news except Tiny Tony’s shenanigans, equities underperformed relative to credit markets and even more so relative to our risk basket.
Typically when we see this kind of divergence, we would argue that this is real selling pressure (as opposed to algos or ‘people’ arbing across correlated asset classes) and the fact that we are still early on in the month (first monday of June and mutual fund money flow expectations) does provide some more confirmation of that.
The S&P lost 18pts in May as IG credit spreads were stable. HY widened a worrisome 25bps, notably underperforming on a relative basis.
May proved the Almanack and every other old-wife right as it saw underperformance in equity and credit markets. Most interestingly for us is the relatively large underperformance of the HY market relative to IG and equity markets which were much more sanguine despite worsening macro situations globally.
‘Good is good and bad is better’ seems to have been the trading theme of the last week or so as performance for the month was saved from a far worse fate thanks to forward-looking expectations of renewed growth or QE3 – whichever fits your long-only investing bias better.
We sound a little jaded in that comment but as should be clear from the chart above, the excitement in the S&P of the last week or so seems considerably more ‘standalone’ than in the credit markets – which we are told are so critical to the continued performance of this ‘recovery’.
In context, comparing the relative HY and IG moves to their 50-day rolling beta, we see that HY underperformed by around 25bps. Interestingly, based on short-run empirical betas between IG, HY, and the S&P, stocks outperformed HY by an equivalent 7.6bps, and stocks underperformed IG by an equivalent 2.8bps which fits with the up-in-quality and up-in-capital-structure theme that has been so evident all month (and in fact since late March).
Despite a plethora of negative macro data, stocks handily outperformed credit, and pretty much every other asset class, from Friday’s close as a late day surge today took us to two week highs in the S&P 500. The margin cut in S&P futures appears to have exaggerated any month-end need-to-be-long-ahead-of-QE3 ebulience as S&P futures ripped to their highs of the day in the last 30mins of the day, notably away from our risk basket (in the chart above) and extending the run of days-outperforming-credit to five-in-a-row.
The last week has seen our equity/vol/skew model-implied HY spread outperform the HY market by almost 35bps and even IG credit has seen a clear shift in momentum away from the up-in-quality / up-in-capital-structure trade back (at least in the short-run) to equities. Whether this is a new trend is unknown but we are definitely biased to the view that equities have shifted too far from ‘relative-value’ here once again and would at minimum use this equity strength to cover more remaining unhedged beta.
Our ETF Arb once again looks attractive as stocks have pulled away from credit/TSYs view of the world and an entry in the $17.75 to $18 (short remember) with a stop at $19.5 and target at $15. The HY-IG decompression trade gave back a little since Friday but remains very healthy in both CDS and ETF land as today caps a rather weak month for HY credit overall.