How The Crash & Rebound Happened In 18 Points

Originally excerpted from The Daily Grail 

Exuberant markets see strong rebound

Sticking to market related news, global equities saw one of their best rallies in a long time on Thursday and Friday. European markets up over 3%, Dubai's stock exchange up a massive 13%, US stocks were up over 2% (the biggest two day rally since December 2011). North Sea Brent oil rallied from $58.16 on 16 December to $63.32 on 18 December, an 8.8% low to high swing in 2 days. Pretty impressive. The VIX index (or fear index) on American equities fell from over 25 on Thursday to today's lows of 15.47, a 41.4% decline on implied volatility as US stocks staged their largest 2 day gain in more than 2 years, even surpassing the up thrust from the lows of September which itself was bonkers.

The chart below will give readers an idea on the extent of the sell off we have seen, and the rebound since the latest and last FOMC meeting of 2014. For why it was a crucial meeting, please read my post following up to last Wednesday's meeting. The chart below depicts how global markets have performed over the last half of 2014. Pretty stellar moves.

  RSX,  the US trade ETF holding a couple of Russian stocks has rallied very strongly,  up around 37% from the lows of $12 carved on 16 December after the CBR restricted the trading of its currency ; notice the incredibly large volumes post CBR's 17% interest rates.  Below Russia is the US equity market which bottomed on 16 December at around 1975 on the S&P 500.  The rally began in earnest 17 December after FOMC released its statement and Chair Yellen's press conference. We are up for the 4th consecutive day, 5% higher from the lows.   Following US equities are  US high yield bonds  proxied by  HYG , and ETF which holds high yield credit and junk bonds. HYG has been a decently accurate barometer for US HY credit over the years. Like its equity counterpart,  HY bottomed on 16 December and has rallied around 4.7% from the lows last week.  This is actually more incredible than the rally we saw in US equites because equities are usually higher beta instruments (meaning they travel more ground) than credit, but in this instance,  HY had actually performed almost as well in % terms for a credit component.  HY spreads have tightened dramatically over the last 5 days.  The up-in-quality investment grade credit proxied by  LQD , an ETF holding corporate bonds rated at or above investment grade, has been  relatively insulated from the calamity  that has struck almost every other market besides the safe havens.  IG credit spreads have tightened slightly  but not significantly. US treasuries have certainly outperforms IG credit, especially the long bond. Again, this proves that the  sell off in most global markets was a result of an external source , which happens to be global oil prices in this case, and not from the bottom up.  Juxtaposing US treasuries (proxied by  TLT , an ETF holding US treasury bonds with maturities of over 20 years) to broad risk (stocks, HY credit, FX, and volatility), it is pretty obvious where the rotation has occurred.  Treasuries and other safe havens (German Bunds, UK gilts, Swiss Government bonds et al) have been delightful beneficiaries of the sell off in broad risk the past 2 weeks.  Even in the US itself, the rotation is very apparent. The US treasury market is the   largest single market   by volume and outstanding securities in the world, excluding the global FX market; this explains why the rally in treasuries was relatively modest despite the mass event-driven liquidations across most risk assets. In the past 5 days, as funds rotated back into equites and risk in general, TLT (treasury duration) underperformed,  falling around 2.9% as the S&P 500 rose close to 5%.   A look across the pond, European markets (and the rest of the world for that matter) has once again proven that  US is the cleanest dirty shirt  in times of panic/crisis. Comparing the selloffs in US equites and European equities (proxied here by  VGK , an ETF holding major European names and with the EuroStoxx 50 as a benchmark), American equities outperformed their European cousins by a good margin, falling only 4.8% versus 8.1% for Europe as a whole.  The rebound also proved the point of America being the most preferred market across the majors ;  VGK is up around 4.9%  low to high, tying with the US's 5% (meaning the underperformance of Europe against the US was not due to beta).  The best equity market performer since 16 December after Russia is the Middle East. In this case, we use  UAE  as an ETF proxy for equites in the Middle East. After its rout for much of 2H14, it posted a  20% bounce  from the lows when oil bottomed on 16 December together with most risk assets. Of course this is expected from region which has been hurt very badly from plunging crude oil prices, a region whose energy production policies have been forcefully cornered by US energy firms. Now that the Middle East has already bitten the tough bullet that is holding production constant despite being in a climate of waning global demand, it is high time that the American oil and has sector paid its share of homage to the   new oil paradigm.    Rounding up the carousel, the Shanghai Composite (as proxied by  MCHI  in USD instead of CNY, an ETF that aims to track the MSCI China index) also found a bottom on 16 December, and has since  rallied a respectable 6.2%  outperforming Europe and the US itself even in USD terms. Note that the CNY has been rather weak thanks to the PBoC's daily Yuan fixing, so the absolute performance of the Chinese equity markets has actually been more stellar. Of course there is an entirely separate set of factors that have weighed and propelled Chinese stocks, but that will be a story for another day.

RSX, the US trade ETF holding a couple of Russian stocks has rallied very strongly, up around 37% from the lows of $12 carved on 16 December after the CBR restricted the trading of its currency; notice the incredibly large volumes post CBR's 17% interest rates.

Below Russia is the US equity market which bottomed on 16 December at around 1975 on the S&P 500. The rally began in earnest 17 December after FOMC released its statement and Chair Yellen's press conference. We are up for the 4th consecutive day, 5% higher from the lows.

Following US equities are US high yield bonds proxied by HYG, and ETF which holds high yield credit and junk bonds. HYG has been a decently accurate barometer for US HY credit over the years. Like its equity counterpart, HY bottomed on 16 December and has rallied around 4.7% from the lows last week. This is actually more incredible than the rally we saw in US equites because equities are usually higher beta instruments (meaning they travel more ground) than credit, but in this instance, HY had actually performed almost as well in % terms for a credit component. HY spreads have tightened dramatically over the last 5 days.

The up-in-quality investment grade credit proxied by LQD, an ETF holding corporate bonds rated at or above investment grade, has been relatively insulated from the calamity that has struck almost every other market besides the safe havens. IG credit spreads have tightened slightly but not significantly. US treasuries have certainly outperforms IG credit, especially the long bond. Again, this proves that the sell off in most global markets was a result of an external source, which happens to be global oil prices in this case, and not from the bottom up.

Juxtaposing US treasuries (proxied by TLT, an ETF holding US treasury bonds with maturities of over 20 years) to broad risk (stocks, HY credit, FX, and volatility), it is pretty obvious where the rotation has occurred. Treasuries and other safe havens (German Bunds, UK gilts, Swiss Government bonds et al) have been delightful beneficiaries of the sell off in broad risk the past 2 weeks. Even in the US itself, the rotation is very apparent. The US treasury market is the largest single market by volume and outstanding securities in the world, excluding the global FX market; this explains why the rally in treasuries was relatively modest despite the mass event-driven liquidations across most risk assets. In the past 5 days, as funds rotated back into equites and risk in general, TLT (treasury duration) underperformed, falling around 2.9% as the S&P 500 rose close to 5%.

A look across the pond, European markets (and the rest of the world for that matter) has once again proven that US is the cleanest dirty shirt in times of panic/crisis. Comparing the selloffs in US equites and European equities (proxied here by VGK, an ETF holding major European names and with the EuroStoxx 50 as a benchmark), American equities outperformed their European cousins by a good margin, falling only 4.8% versus 8.1% for Europe as a whole. The rebound also proved the point of America being the most preferred market across the majors; VGK is up around 4.9% low to high, tying with the US's 5% (meaning the underperformance of Europe against the US was not due to beta).

The best equity market performer since 16 December after Russia is the Middle East. In this case, we use UAE as an ETF proxy for equites in the Middle East. After its rout for much of 2H14, it posted a 20% bounce from the lows when oil bottomed on 16 December together with most risk assets. Of course this is expected from region which has been hurt very badly from plunging crude oil prices, a region whose energy production policies have been forcefully cornered by US energy firms. Now that the Middle East has already bitten the tough bullet that is holding production constant despite being in a climate of waning global demand, it is high time that the American oil and has sector paid its share of homage to the new oil paradigm.

Rounding up the carousel, the Shanghai Composite (as proxied by MCHI in USD instead of CNY, an ETF that aims to track the MSCI China index) also found a bottom on 16 December, and has since rallied a respectable 6.2% outperforming Europe and the US itself even in USD terms. Note that the CNY has been rather weak thanks to the PBoC's daily Yuan fixing, so the absolute performance of the Chinese equity markets has actually been more stellar. Of course there is an entirely separate set of factors that have weighed and propelled Chinese stocks, but that will be a story for another day.

Collectively, global markets have seen their inflection points at or slightly after 16 December when the CBR introduced FX controls and its 7 drastic measures to reign in on the wildly careening ruble and collapsing asset prices. Immediately after the CBR's draconian measures, it was time for the proverbial FOMC to write another set of put options underneath risk assets, and sure enough markets were catapulted much higher following the 17 December FOMC event.

Market participants understand that there was nothing materially different in the last week's statement other than a slight alteration in language. However, whatever prompted the take off in risk still leaves many scratching their heads. Whatever prompted the rotation out of safety and into risk must have been pretty significant that it occurred in a global level. One thing I've learned after more than half a decade in the markets, is that one should never every doubt the ability the convening powers of the world hold. The extreme measures taken by the CBR, and the favorable jawboning by the Fed was a very current example of convening power.

For us to understand the reasons for the abruptness and strength of this rally, we first need to know what caused the sell of in the first place. A lot of forces get intertwined in the maelstrom of a crisis that it becomes blurry. Everyone rushes to the exits, and the market turns hard leaving many half naked in the dust.


What broke the markets?

Without going down this rabbit hole, I think the following linkage might be able to explain the rout we saw:

  1. Declining oil prices were initially seen as a side effect of weakening global growth, no one really thought much about it until the decline became more protracted and significant than normal;
     
  2. When the OPEC summit failed to yield any supply cut from the Middle East, traders and money managers started to panic - the market had then priced in a slight production cut by OPEC;
     
  3. As oil continued to decline, now accelerating in velocity, concerns started spreading - concerns about lower oil prices and more importantly the shift in OPEC's strategy to counter the rise of small and medium shale oil producers in America;
     
  4. At this moment, markets are already crashing in the Middle East - markets there are more tied up to oil prices and hence national revenues from energy exports than anything else, hence Middle-Eastern markets were very highly geared to oil prices;
     
  5. As oil continued to tank, an increasing number of smaller scale producers that leveraged on the shale revolution started to loose money for every marginal barrel of oil they produced. However, if they stopped production, this would mean the Arabs had won via their new strategy to crowd out smaller US producers using low prices - on the basis of them having a much lower per barrel breakeven price than their American competitors;
     
  6. When Brent and Texas Intermediate oil fell below $70, Russian assets and the ruble started collapsing in earnest as the new oil paradigm coupled with financial sanctions took too much of a toll;
     
  7. At the same instance, spreads of HY credit in the oil and gas sector started to explode wider as concerns of bankruptcies due to weakening top lines and consensus that oil prices would remain low for a considerable time into 2015 weighed on confidence. Energy HY credit formed more than 20% of the entire HY credit market in America, and this fact alone meant that the entire HY market started selling off hard way before equities started to even flinch;
     
  8. Russia's CBR hiked its main interest rate by 150bp to 10.5%. This has little to no positive effect on the ruble's performance. USDRUB and the Russian stock market continued on their accelerated trends;
     
  9. By now, Middle-Eastern markets were in their free fall on an entirely different league. Anything that had a sizable exposure to those markets were also brought down;
     
  10. Besides the Arabs, Russia was also on fire by the time Brent printed $67 when the next week opened for trading. Several large European banks had sizable exposures to Russian credit and equity names of large state-owned energy firms and banks (Rosneft, Gazprombank, SMP Bank et al), even a few of PIMCO's funds had roughly 21% exposure to Russia, and in the first week of November (long after Gross had departed), PIMCO saw more than $200mn in withdrawals from funds that had significant exposure to Russia. This gives a good impression of how mass liquidations occurred as things when off in a flurry;
     
  11. European corporate credit, especially financials were one of the first to be hit through the Russian transmission, this sparked selling in the broader equity markets;
     
  12. By now, when Brent was just over $65, US HY spreads had already diverged so far under where US equites were still trading. A few disappointing macro data prints later and equites started selling off, and placed catch up to where HY credit had been traversing all along;
     
  13. Up till now, more insulated markets such as those in the US, Singapore, and UK were still taking their cues from oil. Fast forward less than 36 hours and they were behaving as if they had minds of their own. By then, markets were truly a rout;
     
  14. As Brent touched $60 and Texas $55, the CBR raised rates by 650bp to 17% in an unprecedented move. For about 15 minutes this had an positive impact on the ruble (USDRUB slipped lower a couple of hundred pips), only to erase all its gains moments later. When Europe opened for trading a few hours later, there was mass selling across the board and USDRUB proceeded to test 80, all time lows against the dollar;
     
  15. Trading session after trading session only saw a sea of red as risk was either hedged or unwound entirely. By now, the rotation from risk into safety was more apparent than daylight;
     
  16. The day after the worst day in Russian markets since the 1998 LTCM-Russian default, the CBR announced that it was suspending the trading of the ruble on international FX markets. The CBR also announced 7 measures in response to the mass flight of capital. Multiple FX brokerages stopped offering their retail clients USDRUB for trading the day before;
     
  17. It was at the end of this trading day, the 16 December that global markets bottomed and found their respective inflection points. The FOMC concluded their 2-day meeting on this day and the ensuing statement seemed to propel markets magically higher;
     
  18. The rest, as they say, is history