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What a Week It Was...

Friday was a bad day for stocks which dropped -2.5% on average but stock market corrections can be healthy at times... The trouble is that last Friday also concluded the worst week since February 2009 for so called “risk partity” portfolios that combine stocks and bonds on a risk adjusted basis.

Source: Zerohedge

It was not only stocks and bonds that fell in a synchronized manner on Friday. Precious metals dropped as well, prevented from acting as safe haven due to the technical rebound in the dollar and a further increase in bond yields. This implies that unless you were all in cash or holding large short positions, your portfolio suffered last week.

The rapid increase in cross asset correlation that we referred to  last week and last Thursday is what drove those portfolios into a cross asset selloff  which was a meaningful development in a leveraged system from a portfolio management perspective and a reason to remain cautious all by itself as risk managers are not there to discuss the long term  outlook but to make sure var limits are not exceeded which may force more liquidation. Var consumption is indeed going  to zoom higher now...due to higher volatility and this high cross asset correlation which reduce diversification of most portfolios and certainly those of  “risk parity” portfolios. 

Therefore we need to think about what could support either stocks or bonds over the near term. Bonds are overvalued and bond yields artificially maintained at a low level due to central  bank qe purchases that are going to be tapered progressively. Stocks are expensive because rates are too low and there is a lack of alternative investment. Because yields are so low, people have also been  leveraging credit risk and credit risk premium are also fairly tight. Because volatility has been depressed and is so low historically, people have been selling more options to generate whatever additional yield they could get which means there is  a large ‘negative convexity’ (potential for investors to get more exposed without really wanting it  as the stock market declines).

We are great supporters of “risk parity” portfolios but we are not alone and in a leveraged system, where the only hedge is selling, selling may beget more selling for a while longer than a couple of days. 

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