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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