Correlation or Contagion?
Sally Limantour
The selling continues this morning as the Chinese government this morning has rekindled global slowing concerns. We have taken out last weeks lows and now are focused on China’s promise of increased regulation of banking and real estate as well as the possibility of additional interest rate hikes. We still have our usual suspects lurking in the background – carry trade unwinds, sub-prime home blues, and recession fears. With stocks, commodities and currencies falling across the board a question is circulating across the globe – is this a typical “healthy correction” where contagion kicks in as investors/traders liquidate positions across the board in all asset classes? Or does this have a different premise where the global macro backdrop of different asset classes is so highly correlated that a new paradigm is evolving which will threaten our beloved Goldilocks scenario?
“US demand has come in weaker than expected. Maybe the China story and the sub prime story are linked. The weakness in housing is going to cause real problems in the supply chain to the US consumer and that could be US small caps, or it could be in Asia. The saying these days is that the only thing that goes up when the market goes down is correlation.” --from FT.com article, Feb 28, titled: ‘Correlation rather than contagion’
People are now focused on concerns and until that changes, markets will stay under pressure. Now the hard questions are being asked concerning China and their murky accounting practices, their still stringent capital controls which defacto prevent an exit and the true rights and claims of so called Chinese shareholders (350 out of 500 of the largest listed Chinese stocks are still government owned). In addition questions regarding the private equity market (which is for the most part unregulated and unreported) and its size and risk to the overall banking and financial system are being asked. Not to mention the size of the carry trade unwind and derivative positions. I am not one to get to negative, but as I said last Wednesday we are trying to assess where real liquidity begins and leverage ends. It is a tangled web.
In the short term I expect a short covering rally perhaps early in the week and then further weakness in the equity markets. My shortest term model is getting close to a buy signal and we have the put to call ratio now at a high level. Intraday ranges should continue to be wider than what we became accustomed to and volatility will continue to move higher.
I watched Master and Commander (for the 3rd time) over the weekend and there is a classic scene when the ship is under attack and a small boy is crouching with fear. The Captain pulls him up and says, “stand tall in the quarterdeck,” meaning, be present and responsible. Heading into the week listen carefully to what the market has to say, respect the charts, preserve your capital and trade only with good risk/reward scenarios.
