'It Is What It Is' - Or Is It?

by: The Heisenberg


Some folks will tell you that the "market is always right." Or, equivalently, that "mispricings" don't exist.

I'm going to (very) patiently explain why that is simply not the case.

Then I'm going to issue a challenge related to the pricing of the most important political risk on the planet.

Hopefully, we'll all learn something in the process.

Ok, so it's Monday.

It kind of feels like there should be a lot going on, but there isn't.

Everyone's a bit jittery. There's nothing like the mood you get when record high stock prices collide head on with event risk, and that's exactly the setup ahead of Tuesday night's big speech from Trump.

I've noticed a funny thing over the past couple of days. Well, it's funny to me because I don't have any positions in anything, but if I did, it would be more "alarming" than it would be humorous.

Has anyone else seen this creeping tendency to proclaim that markets can't be mispriced?

I sure have and I don't mean from commenters on posts - although I'd wager that if I went back and read some of them you'd see it there too. Traders are starting to ask whether it's possible - from a kind of philosophical perspective - for markets to be "mispriced". That is, people who do this professionally are asking this question!

Obviously, that's ridiculous, not to mention a bit scary.

In a certain sense nothing is "mispriced." Is a Starbucks white chocolate mocha "mispriced" at $6.56? Well, no. The price is just the price.

Is it "mispriced" based on what went into making it? Well, yes. And for two reasons: 1) there's an absurd brand premium that comes courtesy of that green Starbucks label on the cup, and 2) everything you buy is technically "mispriced" compared to what went into making it because if it wasn't, the company making it wouldn't be able to turn a profit. Think about it. How do you make a profit if your product isn't "mispriced"? That's what profit is. You took some stuff that cost X, made something out of that stuff, then you charged Y. The difference (i.e. the "mispricing") between X and Y is your profit.

People who assert that "the market cannot be mispriced," aren't really saying anything. They think they are, and they want you to think they are. But make no mistake, they're not.

Let me explain why.

Take something like the weather, or the outcome of a war, or say, how I ended things with the nicest girl I ever dated some years ago. Is the weather "wrong" because it was supposed to be sunny today and it rained instead? Well, no. But that doesn't keep you from being upset that you're now caught out in a downpour with no umbrella.

Would it have been "wrong" if the Axis powers had won World War II? Well, no. Again, "wrong" makes no sense there. The outcome would have just been the outcome.

Same thing with the (ex)girlfriend. Is reality "wrong" because it turned out that I'm semi-retired, living on an island and she's likely somewhere babysitting? No, reality can't be "wrong." Reality is just "reality."

But that's all tautological, right? That is, it's not even worth talking about if that's the angle we want to take.

If we introduce no value judgments into the discussion, then we're just saying "it is what it is."

Thus we're saying nothing at all.

So when someone applies that logic to markets, just remember everything said above.

Ok, so having dispensed with that (although I'm sure not once and for all), let's revisit a (very) important market mispricing.

You'll recall that on Monday I presented a new Heisenberg challenge. In that linked post, I presented three charts. I gave readers three labels to apply. I didn't tell you which one went with which chart. That was the challenge.

The point was to highlight the discrepancy in how the market is pricing the risk that Marine Le Pen wins the French presidency and takes France out of the EMU. That is, the task was to identify the asset not correctly pricing a redenomination event.

This is a fantastic study in how markets can certainly be "mispriced" assuming we don't say nothing by saying "the price is the price" or, equivalently, "it is what it is" (and no, there are no typos in there).

As the Heisenberg crowd knows, I've been saying for roughly two months that € corporate credit is mispricing French political risk compared to what sovereign spreads and sovereign CDS are saying.

There are effectively two levels on which we can analyze this. One is at the broad market level. That is, we can look at € IG as a whole and, considering the relative overweight of French corporate debt within the universe of € investment grade debt, analyze the extent to which iTraxx Main and the cash market are mispriced compared to OAT-bund spreads and/or the ISDA basis on 2014 French CDS versus the 2003 contracts. If you're interested in that discussion, please see here and work your way back using the links therein.

The other way we can analyze this issue is by looking within French corporate debt. That is, we can look at how French domestic-law bonds are trading versus their foreign-law counterparts.

Because domestic-law bonds are obviously at greater risk in the event of redenomination, they should be trading wide of foreign-law French bonds. Consider some new commentary out Monday from Citi (my highlights):

In the run-up to the French elections, redenomination risk seems to be on everyone's lips again. Ms. Le Pen may not be expected to win, but her objective to dismantle the euro - or to take France out of it - if she does, is forcing many to reassess exposures. As we have argued previously, the magnitude of these exposures is so large that we suspect the very asymmetric risk/reward will prompt further de-risking over the coming weeks, unless her prospects of victory fade fast.

What strikes us is how 'inefficiently' markets seem to be reacting in that the same redenomination risk is being priced very differently across different asset classes. Most obviously, there is the widening of OAT spreads to Bunds in recent weeks. For much of 2015 and 2016 that spread averaged about 30bp in 10-year, so at 75bp currently there is arguably a 45bp "election premium" - the bulk of which we would argue reflects perceived redenomination risk. Evidently, there is huge uncertainty about how much a new French franc would depreciate following such an event. But Bernard Monot, economic strategist for the Front National, has suggested that if the Front National were elected, the French state would permit a depreciation of the new franc of up to 20% against a basket of euro currencies. And considering that a 20% drop in price is worth about 250bp on a par bond, a 45bp premium clearly means that a non-negligible probability is already priced into the market and that shorting OATs here is a two-way risk.

In contrast, in credit markets there is very little, if any, difference in pricing between French law and international law bonds. As redenomination would presumably take place through legislation applied to all domestic contracts, but not to contracts written in foreign jurisdictions, it is arguably the "purest" way of expressing redenomination risk. To us, unlike in OATs this seems to leave a glaring asymmetry in risk/reward.

Yes, "a glaring asymmetry in risk/reward" or, put differently, a painfully obvious "mispricing."

Note that what Citi is saying is precisely what I was trying to demonstrate in the "Heisenberg challenge" linked above. This is being priced at the sovereign level and in the ISDA basis, but most assuredly not at the corporate level. Let's go to Citi again (my highlights):

Just over 900 bonds in the iBoxx € Corporate index are issued under domestic law compared to just under 870 under foreign law (Figure 8).

The majority of the domestic law bonds are issued by French, German, UK and US corporates. As with the sub-sovereigns we find scant evidence that any redenomination risk is priced into bonds currently. French corporates have underperformed somewhat in recent weeks by not benefiting from the general retracement in credit spreads since the ECB meeting in December, but between the domestic and foreign law bonds the gap is barely 3bp (Figure 12) - implying that the probability of redenomination that is priced in is much, much lower than in OATs, for example.

With risk/reward seemingly so skewed compared to OATs or even CDS, we think there is a strong case for switching from domestic law French corporates and subsovereigns into foreign law alternatives.

The thesis there is so blatantly obvious and so clearly spelled out, that I think it admits of zero ambiguity, but let me drive the point home.

For those who contend that the market is never wrong, or that "mispricings" don't exist, please explain to the rest of us why we should accept virtually the very same risk premium for owning French domestic-law corporate bonds as we would for owning foreign-law French corporate bonds.

That is, please explain to us all why we shouldn't demand more compensation for owning bonds that are subject to redenomination risk than we would demand for bonds that aren't.

Finally, please confirm for us that, because mispricings don't exist and because the market is always right, you would be indifferent when it comes to the compensation you would expect to receive from owning a French corporate bond that is subject to a significant hit if Marine Le Pen wins versus one that isn't.

If you can't do that, then you have confirmed that "it is what it is" is in fact not a viable investment thesis.

You've also implicitly admitted that stocks can indeed be "mispriced."

Thanks for playing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.