Long Vega of Vega – an update on the breadth of the US stock market

Breadth of the US stock market (number of new highs minus number of new lows) is pointing to continued weakness in the markets.

Over the last five years, on average, the price of the S&P 500 index has been about 20% above its long term mean. This dynamic broke down in June-2015 and it coincided with a text-book-correction: dropped 20%, tested support and bounced off. Since then, however, it has struggled to go over 16% of its long term mean. The last two times it tried to get above 16% (Feb-2017) and (May-2017) it turned back down. The market has lost its upside momentum.

Every time the ratio of 1 month S&P 500 volatility to 3 month S&P 500 volatility spikes, it, almost always, is accompanied/followed by a decline in S&P 500. Why would this time be any different?

When an asset that has been appreciating for the last 8 years turns lower even by small amounts, the introduction of negative daily returns to its return distribution tends to increase the volatility of that asset by a meaningful amount. While we are long volatility we think a better trade structure might be to focus on acquiring long exposure to volatility of volatility of the US stock market. In our view, one of the best trades for the next 12 months is to be long Vega of Vega. We will continue to develop this idea and post our thoughts on an ongoing basis.

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Short ICICI Bank – I see; do you?

In India, public sector banks’ advances-policies are dictated by the ministry of finance. Every year, the ministry decides where funding is needed and the banks are given targets for specific sectors and the target-chasing begins. I know this first hand because both my parents were branch managers at two different, such public sector banks and ‘Banking’ was a common dinner-time topic. Private sector banks, on the other hand enjoy a much greater autonomy on their advances-portfolios and as a result are much more efficient in designing them. This is fully discounted in the markets: average P/B of public sector banks is 0.5x versus 2.4x for private sector banks.

ICICI Bank Limited (NYSE: IBN) is the largest private sector bank in India and in our view, ICICI’s common stock is a sell for the following reasons:

  1. ICICI is priced like a private sector bank but its NPAs are comparable to public sector banks.
  2. Heavy exposure to ‘Infrastructure and Energy’ Rising Non Performing Assets (NPAs).
  3. Infrastructure Sector is in limbo due to policy-bottleneck.
  4. Revised Reserve Bank of India (RBI) Guidelines — NPA calculation.
  5. Sky High EPS Growth Expectations. Over the next 5-years, EPS is expected to grow 22% p.a.

As at the end of FY-2016, ICICI had made provisions for less than half of its total gross NPAs. We think they will be forced to make provisions for the remaining NPAs over the next few years, which will drive their EPS and valuations much lower.

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Bullish Natural Gas Services Group

One of the data points we monitor is the demand composition of natural gas. As per the most recent consumption data published by the Energy Information Agency (EIA) there seems to be a strong underbelly of demand building up at a time when prices are near a two decade low. Whether or not this increasing demand will manifest itself in to significant price gains for the commodity is entirely dependent on how fast the supply can keep up with the demand growth. To be safe, even if we assume that new supply will be able to offset any new demand and that prices will stay flat over time, the one thing we can certainly count on is an increase in the number of molecules of natural gas in the pipeline system in the US.

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Breadth of the US Equity Market – Where’s The Damn Towel

As much as we prefer to look at the long term behavior of the advance/decline indicator, how can you not focus on its shorter term behavior when you are long a market that’s making new highs? The health of the S&P 500 index looks terrible as measured by net advances (advances minus declines) on a daily basis. This is not a typical bull market behavior. The fact that we are witnessing negative net advances when the market is supposedly the strongest it has ever been is a screaming anomaly.

This article was chosen for publication on Seeking Alpha. Please click here to read the article.

Update 2 – Breadth of the US Equity Market

If you’ve followed along the previous posts, you know that the breadth of an equity market is a key indicator we watch for clues on the strength of that market. A clear picture has emerged. Please click here to continue reading.

Update 1 – Breadth of the US Equity Market

While the picture still looks muddy the point of inflection, the moment of truth, seems to be very close. It will soon be clear if the 1 year EMA of the new lows (depicted in red in charts above) will cross over the 1 year EMA of the new highs (depicted in green in charts above) invalidating our hypothesis that the previous cross over was a signal to sell short equities. Please click here to continue reading.

Breadth of the US Equity Market

The seven+ year bull market in US equities, which was mostly propelled by the high, Fed induced, equity risk premium, massive financial engineering, and innovation in fracking, is beginning to show signs of cracking. Please click here to continue reading.