markets

Smart Money Sidelined in Risk-On Rally Shows Not All Are ‘Happy’

Updated on
  • Ebbing of trade tensions stokes equity gains worldwide
  • But short interest on bonds signs caution; volatility elevated

The smart money wants more before it’s happy.

As the U.S. appears to step back from an all-out trade war, credit investors are staying away from the relief rally that’s stoked Asian and European stocks and spurred the biggest one-day jump in the S&P 500 Index since August 2015. That came after President Donald Trump tweeted “all will be happy!” with the results of the ongoing trade talks.

Corporate bonds, often seen as a leading indicator for the direction of stocks, suggest skepticism of the equity rally. So too do a handful of other stock market indicators, raising the prospect that investors may be buying into a temporary rebound rather than a durable recovery.

“We do think that the relief rally in the equity market is purely due to the heavy sell-off,” wrote Naeem Aslam, chief market analyst at TF Global Markets in London. “It is more of a dead cat bounce than anything else; if the underlying fundamentals aren’t addressed, we could see the sell triggered again.”

Reports late on Monday said the U.S. was urging China to lower tariffs on cars and open financial services as part of talks to resolve tensions -- steps that would help it avoid tariffs on $50 billion of exports to America. That gave a boost to the current equity rebound.

Yet short interest on the iShares iBoxx Investment Grade Corporate Bond ETF, ticker LQD, relative to its U.S. equity ETF counterpart is near its highest on record. The bearish measure on the junk bond ETF equivalent also sits just below its all-time high. Meanwhile, gauges of both volatility and corporate default risk remain elevated, while yesterday’s sharp jump in stocks hasn’t convinced equity bears to capitulate.

In credit, “the market is taking its time to make sure everything is fine,” said Juan Esteban Valencia, the head of credit strategy at Societe Generale SA in Paris. “If things seem to be cooling down on the trade front then credit spreads should follow equity markets in the coming days.”

For now, weeks of escalating tensions over global trade are keeping credit investors wary after being deluged with 81 billion euros ($100 billion) of new European corporate bond issues, Valencia said, which supported higher risk premiums. The indigestion could ease if the U.S. and China avoid tit-for-tat penalties, he added.

Volatile Rebound

Meanwhile, even as the Cboe Volatility Index begins to retreat, derivatives on the anxiety gauge show concern has hardly abated. The futures curve for the VIX, whose contracts track the implied volatility of the S&P 500 index over time, is in backwardation. In other words, March contracts are more expensive than those expiring in April, May, and so on out.

Backwardation is a tell-tale sign that stress is still built into the market -- typically, contracts for further months are priced higher since the future is less certain. So even as global equities rally, traders are happily paying a premium for a contract betting on another bout of volatility sooner rather than later.

Managers Go Missing

Professional money managers were leery about buying stocks during the rebound Monday, judging from the Smart Money Flow Index, which tracks Dow Jones Industrial Average moves in the first and final 30 minutes of trading.

The thinking is that smart money will test the market and wait until the end of the day before committing to any large moves. The index is hovering near a two-year low and only advanced 1.2 percent Monday, compared to a 2.8 percent advance in the Dow.

Stock Bears

And despite the equity rally, bears have yet to capitulate. During Monday’s U.S. trading session, the Russell 3000 Index jumped 2.6 percent, the biggest daily gain since August 2015. Yet a Goldman Sachs basket that tracks 50 stocks with the highest short interest in the gauge gained only 1.7 percent.

Because the most-shorted stocks lagged, it’s likely that investors have yet to relinquish their bearish bets, according to Tim Emmott, executive director at Olivetree Financial Ltd. in London.

“The price action displayed by the GS most-shorted index yesterday would suggest, at face value, that there was no panic short cover at all last night,” Emmott said in a message. “I would have expected the index to heavily outperform the SPX had conviction amongst shorts/bears been brought into question by the move yesterday.”

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