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Monday, May 17, 2010

I Think We Have Seen This Movie Before

 Although we may not be there yet, according to this analysis  things are starting to look very familiar: Deja Vu all over again ?

Large Market Selloff
Sellloff instensified by leveraged investments, computerized trading and liquidation of hedge funds
All "risk assets" move down simultaneously: US across the board, commodities, developed and emerging market stocks and bonds
In the fixed income area a flight to quality with a large increase in spreads over treasuries for investment grade and high yield corporate bonds
Actual volaitility (VIX) and vix futures move up to extreme levels

The rational response for investors (as opposed to traders)

During the early phases purchase volatility through futures options, vxx or vxz etns. Resist temptation to trade the move by selling off long term positions, shorting or attempting to pick bottoms in commodities or equities.

During later stages monitor fixed income spreads. In 2008 high yield bonds reached a spread of 2000 basis points over treasuries vs a  long term average closer to 500 bp. High grade corporates exceeded 500 bp over treasury when their long term average is well below 100 bp.

These levels are clearly "overshoots" from fair value and at those extreme levels the risk/return in favor of high historic yields and capital gains are skewed in favor of the buyer. Since the default rate factored into such yields is way in excess of a rational expectation of actual defaults, purchasing bonds at such levels is far less risky than trying to pick a bottom for stocks. The lower risk move would be to make purchases as spreads begin to narrow rather than trying to pick an absolute top. Long term investors are likely to be awarded for their discipline and patience in making bond purchases in such market conditions,

Last time this movie played here is what high yield spreads did as stocks tumbled (hats off to bespoke investments)

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