I have two objectives with this week’s missive. I want to contrast what I think are the two prevailing narratives used to explain markets in the first half of the year. And then I want to have a look at the durability of large-cap equity earnings because it seems to be crucial to what happens next. The first story pits the storm chasers against the connectors. The former primarily sees events such as the equity volatility surge in February, the widening LIBOR/OIS spread and the leap in Italian two-year yields as a result of a change in market structure. The ratio of liquidity-providing market makers to crowded trades has shrunk dramatically, creating the condition for face-ripping reversals in consensus and complacent positioning. The storm chasers sees this, and are trying to exploit it. They don’t necessarily ignore the big picture, but they are sufficiently confident in its stability to believe that storms can arise independently of it. Proponents of this view would argue that it is the combination of 15-sigma events and a stable overall environment that is the central story. For example, the fact that the February blow-up of the short vol trade was linked to a bigger story—that the market as a whole would crash—is what makes the initial trade, and the rebound, so attractive.
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