Risk Reversal For Investors

It is doomsday out there! Try to take a bullish point of view and punters and bloggers come for you with a vengeance! What I have found rather remarkable over the last two weeks is the extent to which the crowd has become bearish in such a short period of time. It seems that in just two weeks sentiment has become more or less as bearish as it was at the height of the Global Financial Crisis at the end of 2008. Is this justified? Are we staring down the barrel of the 2nd GFC? I don't think so. I think the recent weakness is more out of fear or what might happen than because of what is actually happening.

Below is the Risk Reversal of the Euro. In essence if gives a representation of the demand for put options relative to calls. It is simply the difference in implied volatilities for out-of-the-money calls and puts. As demand for puts rises relative to calls then option writers oblige by raising the price of puts relative to calls. For me risk reversals give a good representation of how bullish or bearish the crowd is toward a currency. From the chart below you can see that this is the most bearish the crowd has been toward the Euro in the last 5 years. I would guess that this is the most bearish the crowd has ever been toward the Euro! Given the degree to which the crowd is positioned on the bearish side of the Euro I think that the next big move is to the upside - and a rising Euro hasn't been a bearish omen for equities.

Now this is where things get very interesting. Looking at the risk reversals on the NZD, a similar story emerges. Yes the crowd is heavily positioned for downside in the NZD. I guess any trader with half a brain knows what happened in 2008 with the NZD so this time around many traders want in on the action and have jumped the gun in anticipation of a crash in the NZD. Incidentally the Risk Reversal of the Aussie Dollar looks very similar to the Kiwi. Given that the NZD and Aussie dollars are highly correlated to the S&P 500 (SPY) it does not take an economist to work out that the crowd is probably as bearish toward equities as it was at the end of 2008 (more or less). I think the "safe haven" trade (long USD Index, JPY, CHF, USTs, short equities and commodities) about as crowded as it was at the end of 2008. The great Global Financial Crisis of 2008 is still too vivid to investors and any slight sign of trouble sees investors heading for the hills.

It is said that more people lost money in Peter Lynch's Magellan Fund even though it was the best performing mutual fund of its time. It wasn't Peter Lynch who was the problem, rather it was investors' tendency toward buying in at the top and selling out at the bottom. I reiterate what I have been saying since the end of 2008 - the hardest trade to make over the coming months will be to hold on to long positions in equities as the market will do all it can to keep the average investor poor. It was John Templeton who said that "bull markets are born in pessimism, grow in skepticism, mature in optimism, and die in euphoria." I don't sense any optimism around here - let alone euphoria. I think we remain firmly in the pessimism stage and the next big move in the Dow (DIA) will be to the upside over the coming weeks.