Rise Of The Lycans

Rise of the Lycans? Sure!

I mentioned the popularity of the "moral hazard" trade yesterday. Guys at Bespoke Investment Group are quick to compile the data on relative sector performance in August. The lead by "moral hazard" financials like AIG, MBI, C, GNW etc. is stunning ...

However, Brett Steenbarger, the day-trading specialist, has an interesting take on the issue at "The Big Picture":

... I took C, FNM, and FRE and expressed their *composite* volumes (e.g., the volumes transacted across all exchanges) as a fraction of NYSE volume. What we see is that, early in 2007, those three stocks accounted for only 1-3% of NYSE volume. During the financial crisis of late 2008 and again as the market was bottoming in early 2009, that ratio skyrocked to well over 50%.

Recently, however, the volume in these three stocks has hit astronomical levels relative to total NYSE trading, as all three have made phenomenal percentage gains during August. Indeed, the composite volume of these three stocks alone has recently doubled total NYSE volume. If we look at just the NYSE trading of these firms, they are accounting for about 40% of NYSE volume. It is not surprising that Brian would notice TRIN flipping up and down as these stocks change direction.

Again, the question is what all this means. There is no way that mom and pop trader and investor are involved in any meaningful way in generating these kind of daily trading volumes. Nor are proprietary trading shops capable of generating volumes that exceed those of the entire New York Stock Exchange. While I have no doubt that the algorithmic trade close to the market is participating in this movement, the directionality of the involvement suggests that large financial institutions are systematically buying the beaten-up shares of the poster children for TARP: C, FNM, FRE, AIG, and the like.

It is worth noting in this regard that other major (healthy) financial firms, such as GS and JPM, have seen no such surge in their volume or their trading prices.

Macro Man has even more curious observation on the LEH today:

In yesterday's fairly lackluster session, Lehman Brothers-Lehman Bloody Brothers!-stock traded 125 million shares, rising to 18c. In the last two sessions, that share price has more than tripled. Now, Macro Man gathers there is some stuff going on with respect to the vultures picking over the carcass of LEH, fighting for scraps. But he cannot think of any rational reason in the world why anyone would want to buy Lehman common stock....hell, until yesterday's move was pointed out to him, he didn't know that Lehman stock still existed! Gee, he wonders if he can get a quote on Enron or Penn Central...

No wonder that there is so much talk on the divergence of bond yields and equities, even at FT.com (by Richard Cookson, the head of asset allocation research at HSBC) :

Here’s a question that perplexes investors and traders alike: why on earth have government bond yields been falling recently even as equity markets have been climbing?
.............

The benign argument for bond yields (and equities) revolves around supply. Many pundits and investors have been in a lather about the vast quantities of debt that governments have to issue. But if an unexpected mountain of supply raises the risk premium that investors demand for holding longer dated paper, the opposite is also true: supply that becomes less Everest-like than feared would reduce it.

So the benign explanation for why bond yields have been falling even as equity markets have been rallying is that worries about the surge in government bond issuance are lessening as signs of recovery mount.

That in turn should lead to a fall in government issuance and thus long-term yields, especially since inflationary pressures (apart perhaps from the UK) are so muted and yield curves so steep by historical standards.

And if that’s right, lower government bond yields would increase the appeal of riskier assets, equities included.

Effectively, the ex ante equity-risk premium would be driven higher because the long-term risk-free rate, but not the growth rate, would be lower.

Sadly, there’s also an altogether more malign explanation. Much as was the case in Japan in the 1990s, it could be that low government bond yields are telling you that this recovery is unsustainable once the monetary and fiscal medicine wears off.

It could be saying that, thanks to the required private sector deleveraging, especially in the US and UK, the long-term potential growth rate of the developed world is much lower than it was. That would lead to a sharply lower ex ante equity risk premium and thus potentially dreadful returns from equities.

This distinction matters as much for coming months as for coming years. Those of a bullish disposition argue that huge operational gearing, the result of all that cost-cutting, will mean that any top-line growth will lead to a surge in corporate profit. Apparently heady current valuations will melt away like snow on the water as these profits come through.

If bond yields have fallen precisely because growth is likely to be more sustainable, that would make sense. But if bond yields have fallen because, as with Japan in the 1990s, bond investors are worried about the sustainability of growth, equity markets themselves look likely to melt.

The jury is still out there ...