Friday, January 17, 2014

FW: Are you ready for the big crash??

Zervos For Dummies

SPOO = S&P 500 index futures
VIX = trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options
MOVE = The Merrill lynch Option Volatility Estimate (MOVE) Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options
3M EURUSD = Three month Euro ~ U.S. Dollar cross currency swap, also referred to as cross currency interest rate swap, which is an agreement between two parties to exchange interest payments and principals denominated in two different currencies
PIIG = Portugal, Italy, Ireland, Greece

"We hold these truths to be sacred & undeniable; that all men are created equal & independant, that from that equal creation they derive rights inherent & inalienable, among which are the preservation of life, & liberty, & the pursuit of happiness; ..." ~ Thomas Jefferson

John Broussard
State of Louisiana
Department of the Treasury

-----Original Message-----
From: David Zervos (JEFFERIES LLC) []
Sent: Friday, January 17, 2014 8:18 AM
To: John Broussard
Subject: Are you ready for the big crash??

Catchy title huh? But I'm sorry to disappoint all the haters out there, I will not be referring to a crash in risk assets. I will leave that exercise in futility for the doomsayers and goldbugs who have been calling for Armegeddon since 900 on the spoo! Instead I'm going to discuss the crash that has engulfed all asset markets. The crash that is with us everyday now. The crash that was engineered by global central bankers over the past 5 years. The crash that makes everyone want to increase leverage and place bigger and bigger bets on smaller and smaller amounts of equity capital. Of course you have probably guessed it by now, I'm speaking about the great crash in volatility!!

As most folks are fully aware, the VIX can barley hold a 12 handle, the MOVE index is about to trade with a 5 handle and 3m EURUSD vol may not even have a 6 handle in a few more weeks. The developed market central bankers have guided us, backstopped us and conditioned us to such a point that tail risk in nearly nonexistent in nearly all major asset markets. That said, we have had our share of scares in the past 5 years - the PIIGS, the US fiscal follies, Cyprus, and even communication mistakes by the FOMC. But after endless backstopping, the developed markets have been left with nothing to fret about. In fact, the haters are so starved for potential crisis they are looking for global systemic risks in Detroit, Puerto Rico and the student loan market......pullllease!

In the end, the continuous execution of these developed market central bank backstops - the Bernanke Put, the Draghi Put, the Kuroda Put and the King Put - caused risk assets to rip. The BTD (buy the dip) strategy was the winner, and the STD (sell the dip) strategy left everyone who followed it with an unpleasant disease called poverty. In other words, QE and central bank balance sheet expansion worked. Assets have reflated, real rates have dropped and markets have stabilized. Now we get to sit back and watch folks who haven't owned risk assets chase them. Further, we get to see leverage enter the market and eventually create the next bubble (and of course the next firesale).

The most interesting question centers upon where that leverage bubble will come from. The jury is still out, but my guess is that with financial regulation on the rise it will not come from banks and fund managers. It will not come from structured products, repo or securistization. Those were the seeds of the last crisis. Instead, the leverage will enter through corporate balance sheets - a place where regulators are not focused. As the developed market economies continue down the path of a reflationary recovery, corporates will continue to buy back equity, engage in leveraged buyouts, increase M&A activity in generally speaking increase operating leverage. The next bubble will come from confident corporates, who have excessive quantities of cash on their balance sheet. As soon as the household balance sheet comes to life (which it hasn't yet) these corporates will lever themselves like a couple of Nobel Laureate finance professors turned hedge fund managers in Greenwich CT. But it won't happen with the boring old "value" stocks. It will be "growth" stocks that feed at the leverage trough. Sentiment is always the bubble driver! So that's why it is time to add some spicy Q's to those more stable Spoos. Vol is crashing, and risk assets are heading into the next phase of the recovery period - the euphoria phase. Meet the new bubble, same as the old bubble. And welcome back to the 90s!! Good luck trading.

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