What Do They See That We Don’t? Global/Domestic Risk Divergence
Over the course of the credit crisis global risk aversion has led domestic risk aversion. Even though the fundamentals in the domestic economy triggered the sell off, such as the failure of Bear Sterns and the following revelation of subprime exposure, equities markets refused to believe the bad news even as the carry trade began to collapse. As the US government rushed to the aid of the financial sector in August-October of 2007, equities traders took this as a sign that all was well and pushed stocks to new highs in October of that year. However the carry trade did not rise and it was clear the market was extremely long on risk.
At that point I knew that the divergence I was seeing illustrated a very serious situation which the equity markets were not taking seriously due to their perennially bullish bias. I got very bearish on the stock market and took a large short position in GBP/CHF at the beginning of November 2007. I made about 200 pips and left 18,800 on the table. I only would have had to wait a year.
In the subsequent months to follow, the GBP/JPY kept pushing lower as risk was liquidated and borrowed yen was repaid en masse. Each new low was followed by a new low in the stock markets. Failing to see the global picture, they continued to believe the situation was better than it was. When stocks bottomed out in March, they climbed hard dragging global risk assumption with them.
But recently as the S&P 500 has broken above 1000, we are seeing balance-sheet bankrupt financial companies being bought like candy, very poor PE ratios, and a downturn in global risk again. You can see this divergence on the chart below. The green line is the GBP/JPY, representing global risk. The red candles are the S&P 500. You can see at the very end how global risk has chopped lower but equities have risen. I am guessing that the market anticipates a bullish third quarter and so they have positioned themselves for it. If past correlations are any indication, September may show a sharp correction.
This week’s fundamental news will be a key indicator. If bad news is taken seriously or if good news gets a weak response, we are probably in for a correction. If bad news is shrugged off and good news is bid hard, then this bull leg could last longer or range. Either way this week will be pivotal because this divergence cannot last.
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