Of late there has been very little to feel overly excited about in the market.
The majority of the important data seems to fall far short of expectations and the majority of the earnings season mixed. So too was the highly anticipated results of the Stress Tests for European Banks, which was awaited with much anticipation and bated breath last week.
It was rather interesting that the results would be coming out at the close of the European markets on a Friday, while North America was still open; but even more so, that what was meant to create one assumes greater transparency, was not necessarily the case.
In the end the results were published/leaked earlier than the time stated by CEBS and in typically cynical fashion the market gave it the secret thumbs down.
The conversation seems to have focused on there being a whitewash for the less than stringent rules being applied.
Why so surprised I ask?
Seems to me that it was no different for the other bank stress tests we have seen in the last year, so naturally market reaction was hardly positive.
This provides a nice sequitur for my next point which is the question of what kind of day we will deal with on market open. In the case of the result of said stress tests it was a risk off day, and reading headlines this morning as I journey the GO Train, its risk on once more.
This has been the pattern for some time now during this crisis (its not over). Yesterday, I read a rather good piece on the nature of risk-on, risk-off market from one of Shrill Bill's PM's from Pimco, Richard Clarida, who I had heard previously mentioned off based on his very interesting dissertations at this years CFA forum in Boston. Titled the Schizophrenic Risk On, Risk Off Market.
His assertion is that the fundamental nature of the market is changing and the degree of volatility has increased based on the greater number of fat tail events and the flatter normal distribution, creating what might be called a "new normal"
He used the following quote from Bloomberg writer Mark Gilbert to introduce and underscore the notion
"The 'New Normal'...turns out to be a world where scenarios move from impossible to inevitable without even pausing at improbable. Flocks of black swans go winging by with a frequency that is dulling our sensitivity to just how extraordinary these financial times are. Call it crisis fatigue." - Mark Gilbert, Bloomberg, June 2010
The piece is quite thought provoking as it also acknowledges the fact that with a large percentage of the shadow banking system (securitization) now gone, deleveraging taking place and as a client in Ottawa pointed out to me,
"some distributions have undefined means because tails are too fat" thus. "if returns are clustered around mean, then you increase leverage".
Clearly as these returns are not (i.e. clustered around the mean) because of the number of fat tails and the breakdown of the shadow banking system, the implication to me suggests some type of potential for a paradigm shift on how market are traded with much larger degrees of volatility. (Maybe of the three market behavioural books recently purchased based on Soc Gen's Dylan Grice's recommendation holds the answer).
As Mr. Clarida puts it "Now and for the foreseeable future, we are in a world in which average outcomes - for growth, inflation, corporate and sovereign defaults, and the investment returns driven by these outcomes - will matter less and less for investors and policymakers. This is because we are in a New Normal world in which the distribution of outcomes is flatter and the tails are fatter. As such, the mean of the distribution becomes an observation that is very rarely realized," **** [Zero Hedge]
The term fat tail is a reference to the tendency of many financial instrument price and return distributions to have more observations in the tails and to be thinner in the midrange than a normal distribution. Assets prone to price jumps tend to exhibit fat-tailed distributions. Courtesy John A. Robb
His take away, being three points discussed above. Managing fat tails (good luck), the risk-on, risk-off mentality as a direct result of those fat tails leading to obviously greater vol directed by the reaction to "news and data bombs" and finally lower leverage, which with the reduction of liquidity (read leverage) from the shadow banking system, naturally makes it more challenging.
By the way its risk-on day today as we had favourable data coming out of Europe including some bank earnings (UBS, Deutsche) giving European equities a a lift and rates cheapening up, so markets off to a positive start overseas and looking that way for this side of the pond.
