ZH: How An Equity Market Prices In Recession

Tyler Durden's picture

Submitted by Tyler Durden on 06/29/2011 17:37 -0400
Submitted by Tony Pallotta of Macro Story

How An Equity Market Prices In Recession

I’m not going to even begin to try and make sense out of today’s market. Watching fires burn and teargas fired in Greece, 100 pip moves in the EUR/USD in minutes and computer algos tripping over each other was surreal beyond words. This market right now is a lottery.  Calling equities forward looking or a pricing mechanism is beyond ridiculous.

It is during noisy times like these that investors must step back and keep things in perspective. Trading on days like today requires little skill and a lot of luck. When I step back I see a deteriorating economy and an equity market trying to understand what to do.  Do they “price in” a soft patch or a full blow recession. Market participants are told it is in fact a soft patch.  The slightest hint of positive data reinforces those views.

Using history as an example I want to share with you the 2007 “soft patch” and how equity markets priced in that economic headwind as well.

Below are a few notable quotes discussing the soft patch which in fact was a recession that began in December 2007 with Q1 2008 the first full quarter of contraction at minus 0.7% from the plus 2.9% in Q4 2007 (my how fast things can change).

  • “We anticipate a soft patch in the middle of next year.” – Morgan Stanley December 6, 2007
  • “The economy is in a soft patch right now” – Mike Moran of Daiwa Securities December 23, 2007
  • “Meanwhile, the Goldilocks economy remains alive and well.” –  Larry Kudlow January 4, 2008
  • “The Federal Reserve is not currently forecasting a recession. It is however forecasting slow growth” – Fed Chairman Bernanke January 10, 2008

The following side by side comparison of the current SPX and that of December 2007 is messy but “bear” with me as the similarities are rather interesting. This is not an Elliott Wave analysis either. Notice the relationship among Point A, B, C, D and E on both charts.

The two highs of the topping pattern are Point A and C with  C being slightly above A (imagine those technicians declaring a breakout).

The two lows of the corrections are Point B and D with D being slightly above B (imagine those technicians saying we put in a higher low thus bullish for price).

Point E is the question in terms of where we are now.  Using the current trend lines off the 1,370 high SPX 1,320 would be the modern day Point E.

Equity markets struggled in 2007 to price in the recession efficiently and were only two months forward looking.  In this highly leveraged, exuberant and low cash market why are we to think 2011 is any different?

via Zero Hedge


Market Conditions: 6/28/11

  • The “Greek austerity measures” i.e. Greece’s second bailout in 1 year is scheduled to pass Wednesday and the market is buying going into the vote.
  • Sequence of events last year:
  1. April 26 – market indices hit two year highs. SPX @ 1220, DJIA @ 11260
  2. Early May – riots in Greece were being broadcast on CNBC
  3. May 6 – queue flash crash. DJIA drops 1,000 points before recovering hitting intraday lows of 9870. SPX drops 100 points hitting lows of 1065.
  4. May 9 – Europe approves a trillion dollar rescue package creating the European Financial Stability Facility and Greece gets a €110 billion loan.
  • The second Greek bailout which will be passed tomorrow is going to be over €120 billion. If you feel like being a philanthropist I hear the yield in Greek bonds is more than 30%.
  • US markets have been pricing in the vote over the last two days giving investors short term profits and an illusion of market strength. Come Thursday the money will remember that the end of the month marks the end of QE2 and the dollar will continue its deflationary uptrend forcing equity to feel the pain of lower prices from a stronger dollar.
  • 10-Year notes saw a significant nominal drop from this activity.
  • Food prices (corn, wheat, sugar) are rising to their highs of last week and will drop back down to their lows after the news has disseminated through the market.
  • The /ES bounced off the highs from 6/7/11 and is selling off slightly in the after hours session but relatively holding its closing price.
  • The current activity is a repeat of the FOMC decision last Wednesday when overly exuberant investors hoped for another round of stimulus to prop up the market. Even though during the days leading into the announcement it was made clear to the public there would be no 3rd round of QE there was still wild speculative buying on 6/20 and 6/21 which led to an identical move down over the following two days starting at 11:25am (10 minutes after the Bernanke aka Bertanke started speaking). I have to say the balance here is quite impressive wrt the time and magnitude of the move up being essentially identical to the time and magnitude of the move down with the Wed FOMC coming right in the middle. I’m looking forward to watching this all play out and have nothing but love for volatile markets.


SMB: The unprofessional summer trader

This is the time when all the tweets and blogs start about hitting the links, or grabbing drinks early, or heading for the beach.  If you have ever traded prop at a big firm you will see seats empty on Friday after 1pm.  There will be many who do not come back from lunch on a Thursday.  Missed Mondays and long weekends are a given.  I just do not get this.

When I first started trading we considered it a privilege to be connected to the inside market.   Well it is.   It was not that long ago when the banks had a monopoly on connectedness to the inside market.  Never forget that.  Trading is a privilege.

In this world of over-stimulation and immediate feedback do young traders expect too much action all-the-time from the market?  If you have to sit and just watch stocks trade from 11am to the close without a trade is that so horrible?  You are not laying concrete on an overheated highway.  You are sitting in a comfortable chair, A/C blasting, surrounded by friends, with access to the internet and music and TV.  Part of trading is waiting, just being on your desk, ready to pounce on an unexpected opportunity.

If you do not have a vacation planned then sit in your seat and focus.  Trading does not mean always having positions. A great deal of trading is gathering data so that you can gain an edge for a future trade.  That might be intraday, or the next session or next week.  But if you not at your seat because you deemed a session too uninteresting for your full focus then you are not preparing yourself for that next great trading opportunity.  This is not you at your best as a trader.

Once you accept that you can conclude a day not worth your full attention you become a lesser trader.  If you step onto a trading floor you are there to work.  All day.  With all your focus.  Anything less is unprofessional.



Parabolic Reversal Dates

4/28 – SLV, SOHU
4/19 – SINA
2/14 – SWKS

Algorithms Used By Financial Institutions

Enhanced DMA strategies

  • Iceberging: Large order is partially hidden. Max shares shown used as input.
  • Pegging: Order is sent with dynamic price that changes according to market conditions.
  • Smart order routing: Liquidity is aggregated from several sources. Orders are matched to the best price and liquidity.
  • Simple time slicing: Order is split and market orders are sent at regular time intervals.
  • MOC: Order is sent into the closing auction.
Quantitative algorithms
  • VWAP: Uses standard VWAP as a benchmark and attempts to distribute large volume at the best price adjusting for volume traded in the period.
  • TWAP: Similar to VWAP but uses time instead of volume.
  • Participate [Inline, Follow, With Volume, POV]: Trades volume using a fraction as input.
  • MOC: Enhanced MOC with optimized risk and impact.
  • Implementation Shortfall (Execution Shortfall, Arrival Price): Manages the trade off between impact and risk to execute trades as close as possible to a target midpoint .
– A buy-side handbook Algorithmic Trading

Financial Models

The aim of financial models

  • Models are used to rank securities by value
  • Models are used to interpolate from liquid prices to illiquid ones
  • Models transform intuitive linear quantities into nonlinear dollar values

The right way to use models

  • Avoid too much axiomatization
  • Good models are vulgar in a sophisticated way
  • Start with a model and overlay it with common sense and experience
  • Know what’s assumed and what has been removed
  • Think of models as Gedanken Experiments
  • Beware of idolatry
It takes intuition to discover theories. Intuition may sound casual but it results from intimate knowledge acquired by careful observation and painstaking effort.
When you struggle with a field of inquiry for a long time and you eventually master and incorporate not only its formalism but its content,, you can make use of it to build things one level higher.
Intuition is a merging of the understander with the understood. It is the deepest kind of knowledge.
– Excerpt taken from “Metaphors, Models & Theories” by Emanuel Derman

/DX Strength

The US dollar has found support. It’s showing strong up volume and continues to have a high inverse correlation with commodities.


The ratio is in free fall.

Q1 Earnings

AAPL – vert + 2 butterflys
4/25 NFLX – diag + vert + 2 butterflys
4/26 AMZN – diag + vert + 2 butterflys
4/27 BIDU – IC + 2 butterflys
4/28 MSFT – 2 calendars + IC

Other Earnings
4/26 DAL
4/29b CAT

SLV 20ema Retracement

Silver margin requirements raised leading a large selloff in /Si today.

SLV seems to find support at the 20ema.