September 11, 2020
By Steve Blumenthal
“We are in the midst in what we old fogeys tend to call a sell-stop avalanche.
It happened before in history and most of them look like this.
I know there are several theories about what has been causing the recent sharp
weakness, but based on over six decades of time on Wall Street
this one looks pretty clear to me. So, let’s discuss how such a thing sets
up and you will begin to recognize its familiarity.”
– Art Cashin
Managing Director and Director of Floor Operations, UBS Financial Services, Inc.
Familiarity. You can read about a particular circumstance in a book and think you know all about it. But true learning comes from real life experience. Few have sat at the epicenter of the global capital markets longer than Art Cashin. Art knows what sits on the specialists’ books. You’d know too if you spent almost every day of your life on the New York Stock Exchange and had established yourself to so many as a principled and trusted individual and friend. (Note to all the new Robinhood traders: Listen to Art. Listen to ART. LISTEN TO ART.)
In today’s post, I share two important pieces. The first, from Art, will help you better understand the human behavior that leads to parabolic market moves (tops) and how stop-loss orders can trigger an avalanche of forced selling. The second, from good friend Ben Hunt will help you better understand the complexities of today’s market—insights further enhanced by his very fun and witty way. If you watched the movie The Matrix, you’ll really appreciate his letter.
Before you jump in, let’s touch base on a point that came up yesterday during a Felix Zulauf webinar. I’ve been a subscriber to Felix’s institutional research service for several years. He is one of the clearest macro-thinkers I know. You may recall me writing about him in past letters, including a June piece called, On My Radar: Euphoria Déjà Vu. Here is the link to a transcript of his discussion with Grant Williams during the 2020 Mauldin Economics Virtual Strategic Investment Conference. Let’s look back at a small part of that discussion:
GRANT: So, you know, it’s interesting because what I’m hearing is that the tools they (the Fed and other central bankers) have available to them today, which they didn’t have in the late 20s, early 30s, are around the kind of restrictions that the gold standard put on. So, yes, they can print. They can run up huge deficits now, which hopefully will alleviate the pressures caused by the main problem in a depression, which was unemployment from a societal point of view. But there will be other unintended consequences. So just walk us through your thought process if they throw everything at this, which they seem to be committed to doing already. How does that come back to bite them? What are the things that we need to look out for in terms of the negative side effects of this policy that we’re seeing?
FELIX: Well, obviously, when you are in a balance sheet repair process, you do not take up new debt, and if you do not take up new debt in a credit-based economy, you cannot grow.
- You know, it’s as simple as that. So the private sector won’t grow by much. It’s impossible in this sort of environment.
- What you can do is the government sector can step in. And the government sector can replace part of the lagging demand from the private sector. But then you go into more government expenditures, work programs, et cetera, et cetera, and you finance all by printing money, and the central bank buys the debt, et cetera, et cetera. You can do that.
- When you do that, you create a less efficient economy—you create more debt. More debt eventually reduces the productivity of debt. I think Lacy Hunt did a great job in showing that in his presentationand the velocity of money continues to decline.
- So that means the central bank can shovel as much money into the system as they want, but you do not get the private sector taking that money as a loan and do something in economic activity terms. For instance, in March and April, the Fed put a lot of—injected a lot of money into the banking system. It goes all through the banking system. The immediate consequence was that the banking system in the U.S. grew by about 12 percent immediately. That hit the point where the banks hit the border of the capital adequacy function. That means they cannot lend anymore because their asset base has ballooned. That means it curtails the lending process in a sense.
- So these are unintended consequences that are happening in the very short-term, actually. In the long-term, zero interest rates, lead to a planning economy, a planning economic system. And you—I don’t have to tell you a communist system is not efficient.
- It doesn’t create prosperity. It leads to political backlash. It leads to a revolution against the authorities, et cetera, et cetera.
Felix’s views are similar now as they were then. One of his big concerns is that banks aren’t lending; they’re tightening like they did in early 2008. In addition, business balance sheets have been hit hard by COVID-19. Repairing them means less investment and the lowering of expenses (in the form of job cuts and salary reductions). The debt binge that corporations were on is over.
If you’ve been reading OMR for some time, you know that this conversation is nothing new. What’s new is that it is now happening. Felix said, “There is no GDP growth without loan growth.” He expects negative economic surprises for the rest of the year. I expect defaults to continue to rise. Things gets real when the lending conditions dry up. It’s about to get real.
Like 1999, money is flowing into just a few tech names. Over the last six years, the “S&P 495” stocks are up approximately 30%. As such, $100,000 is now worth approximately $130,000. The “S&P 5” (Apple, Microsoft, Alphabet (Google), Amazon, and Facebook) is up over 400%—$100,000 is now worth approximately $400,000. This is a highly concentrated market, which brings me to what I want to share with you today.
Clients are calling advisors wanting in on the action. Why? That 30% gain over six years is not cutting it. Strong advisors explain what is actually going on. Weak advisors fear losing their clients, so they put them into those exciting stocks. That’s what’s happening. Such a high concentration in just a few names is nothing new.
The thing is euphoria doesn’t come along every day—it’s more like every decade or so. Tech in 1999, housing in 2007, tech again in 2020. It was the Nifty Fifty stocks in the 1960s and energy in the early 1980s.
Art Cashin describes what to look for to identify parabolic tops. He explains how the accumulation of stop-sell orders on the specialists’ books, all in the handful of stocks investors have herded into, leads to a market avalanche. To quote Art:
You must remember there are hundreds of people elsewhere doing all this stuff so there are going to be stop orders all over the specialist book and that’s what helps make for the avalanche when they start to get interactive. The process quite frankly begins whenever the market begins to zero in on one sector, whether it is techs or energy or whatever, and those group seems to keep going up and up and up, and money managers begin to look at it and begin to say, I think they are overbought but I’ve got to participate or my fund is going to underperform. At the same time the amateurs are looking and saying, the energy stocks just keep going up and up. So, everybody then decides to try capture the momentum. Even though stocks look probably overbought in the sector, they begin buying, and what they do to avoid being caught deeply off base is to follow their purchases with trailing tight sell stop orders.
Art’s full post is below. And do read good Ben Hunt’s missive, entitled “Invisible Threads.” I promise you’ll enjoy it. Here’s a tease:
This is the concluding Epsilon Theory note of a trilogy on coping with the Golden Age of the Central Banker, where a policy-driven bull market has combined with a machine-driven market structure to play you false.”
Ben adds, “Today’s note digs into the dynamics of the machine-driven market structure, which gets far less attention than Fed monetary policy but is no less important, to identify what I think is an unrecognized structural risk facing both traders and investors here in the Brave New World of modern markets.
I think Art’s and Ben’s missives go hand in hand. By the way, parabolic moves tend to peak about two years after they start. They end in euphoria. Two years from the start of the current mania takes us to late this year. Johnny Day Trader is so sure he has figured out how to trade. That’s warning enough… Lights on.
Keep an eye on Trade Signals. I share a number of equity and fixed income trend signals each week, including the 50-day over 200-day moving average cross and 200-day moving average crosses. Since that’s what most people use, I would recommend employing something else as well. The more people who set stops at common triggers, the greater the avalanche. Thus, the importance of Art’s message.
Consider a tighter stop-loss trigger unless you have a stock you plan on owning for ten years. I have no intention of selling my single largest holding, no matter what happens to the stock market. And take a look at high and growing dividend stocks. A high conviction portfolio of roughly twenty stocks yields approximately 4.5% today. It’s for people who want to get paid from their investment portfolio and want their payments to grow. From 2000-2010, tech and large cap-weighted indices lost money. Ten years, negative return. High and growing dividend payers did ok. They did well from 2000-2010. No one wanted value in 1999 and no one wants value today. The best opportunities come when no one wants them. But that’s what makes investing hard. I think Johnny Day Trader is about to learn a hard life lesson.
If the dividends rise as expected, consider something a little quicker—especially given what Art is saying. None are perfect; thus, I favor diversifying to several proprietary processes. The key is to defend wealth.
Grab that coffee and find your favorite chair. Enjoy Art’s short missive and Ben’s very fun and witty post.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- Art Cashin – A Sell-Stop Avalanche
- Ben Hunt – “Invisible Threads: Matrix Edition”
- Trade Signals – Zweig Bond Model Back in a Buy Signal
- Personal Note – Coach
Good friend David Kotok sent a note on Thursday sharing an important market observation from Wall Street legend Art Cashin. You may be familiar with Art already. He is a floor broker on the NYSE and works for UBS. He is also a popular CNBC commentator, offering his insights from the trading floor, and as David beautifully puts it, “a dear friend and marvelous and sensitive gentleman.” Art was kind enough to give David permission to share his morning missive with readers. And both were kind to give me permission to share it with you. You’ll find Wednesday’s and Thursday’s posts here. Read both.
From Art’s Wednesday post – September 9, 2020
The overnight whipsaw in the averages continues, which I think tremendously underscores the thesis I explored yesterday about the dominating influence trading against sell stops and momentum players. Several of my widely read friends have honored me by asking permission to reprint it because after seeing it, they recognized the clarity of explanation it provides. You see again this morning two things to underscore it. First, a whip back in markets after the heavy sell-off yesterday, without any major news. Secondarily, the disparity within markets, in which we see things like the Chinese markets weaker. Yet the bounce-back rally continues in the U.S. So, the actions are somewhat internalized here and we will have to continue to watch out for how that trades. The election may soon begin to press its influence, although the polls remain vague enough that there is no real sense of how things may be moving.
Please remember that sell stops may be behind some of these swings and at least that will provide some backdrop that eliminates the sense of mindless trading and how the market seems to be positioned. We will explore how condition changes may adjust this in coming days.
From Art’s Thursday post – September 10, 2020
We are in the midst in what we old fogeys tend to call a sell-stop avalanche. It happened before in history and most of them look like this. I know there are several theories about what has been causing the recent sharp weakness, but based on over six decades of time on Wall Street this one looks pretty clear to me. So, let’s discuss how such a thing sets up and you will begin to recognize its familiarity.
Sell stop orders have been a key feature in markets for probably over 5000 years, since the ancient Sumerians began trading futures on their grain crops each year. And, the idea, as we said, was to protect you from a deep reversal. There is some belief that sell stops may have even been a factor in the great tulip bulb bubble that burst, but I cannot find any strong evidence either way. If you want to read how sophisticated the market was, see if you can find a copy of something called Confusion de Confusiones. It was a book written in Latin at the time about markets and tulips, etc.
Anyway, back to our topic. So, now you have both amateurs and professionals for their own separate reasons trying to capture the momentum of this particular sector or the market and follow it up with sell stop orders. As I say, stop orders have been around. They really blossomed in the late 50s and early 60s, when a professional dancer named Nicolas Darvas wrote a book about how he took a couple of grand and turned it into over two million dollars. The book was a major sellout and then burgeoning brokerages at the time were forced to grapple with the emergence of a new factor – huge influxes of sell stop orders that caused high volatility. The exchanges at the time scrambled to try and find new rules and procedures that could cushion the blow. Even though Darvas’s theory never caught on completely, it still remains, and anyone will tell you the best way to play momentum is to follow with trailing sell orders. How tight you make the orders depends on what kind of sell-off you are worried about. You want to keep with the trend but you don’t want to be there if the trend is going to reverse so you will probably check on some technical pattern and, say markets are okay, unless they reverse 3% or 6% or whatever and, therefore, based on that technical theory, that’s where you will put in your sell stops.
Now, you must remember there are hundreds of people elsewhere doing all this stuff so there are going to be stop orders all over the specialist book and that’s what helps make for the avalanche when they start to get interactive.
The process quite frankly begins whenever the market begins to zero in on one sector, whether it is techs or energy or whatever, and those groups seems to keep going up and up and up, and money managers begin to look at it and begin to say, I think they are overbought but I’ve got to participate or my fund is going to underperform. At the same time the amateurs are looking and saying, the energy stocks just keep going up and up. So, everybody then decides to try capture the momentum. Even though stocks look probably overbought in the sector, they begin buying, and what they do to avoid being caught deeply off base is to follow their purchases with trailing tight sell stop orders. In essence, if the market trades to 50, they bring their sell stop up to 48. If it then goes to 52, they bring it up to 50, etc., etc.
Frequently, before the phenomenon ends, there is usually a new wrinkle called going parabolic, in which the stock that has been rising relentlessly suddenly begins to move up, almost in a straight line, looking like a parabola.
Now, sometimes the reason for this is just very simply that everybody finally decides to join the pack. Don’t fight them. They are winning. XYZ goes up and up and up. I might as well get in.
Sometimes it can be a news-related event like the recent series of stock splits that we saw, which caused rounds of short covering and mini-short squeezes as people have to go out and buy more stock to replace or reset the stock that they had borrowed when they first got involved in shorting. The shorts being forced to cover was a recent event or you had people saying I can’t win; I might as well just join the pack. In either case, it brings in new buyers on top of the others and that causes the stock to get up nearly in a straight line called going parabolic.
Going parabolic quite frequently occurs as the cycle is shifting toward its end phase. The difficulty is that people cannot time that shift. More than a few people have shot themselves in the foot, saying, it has gone; I’m going to short it here. When it collapses, I will buy it back.
The market can stay irrational longer than you can stay insolvent.
By my recollection, more than half of these sell stop avalanches end in pretty much a washout and that is because they quickly interact so fast that they take it to a level no one had placed previous stops at.
This morning looked like it had some potential as a possible washout. Declines beat advances over 8 to 1. Usually washouts begin at 9 to 1, all the way up to 15 to 1 or more, but the market quickly tried to correct itself. And, while price-wise it is still showing significant losses, the breadth of the market has healed up a little too fast to make you feel that what you are seeing is ‘throw the baby out with the bath water.’
So, we may have to watch for a bit more. I hope I have not bored you with my recordation of what I remembered from 6½ decades.
Stay safe and we will look again tomorrow.
Both David and Art write excellent letters.
Click here to sign up for David Kotok’s free letter. Send me a note if you’d like to get on Art’s daily email list, and/or if you’d like to learn more about our high and growing dividend portfolio of roughly twenty stocks.
September 9, 2020
Editor’s Note: On August 24th, 2015 – almost exactly five years ago – we had a flash crash in the S&P 500 when the VIX didn’t price correctly one morning and the invisible thread of option gamma that holds the market together was snipped. And so everyone got gamma-squeezed whether they knew what gamma was or not.
In August 2020 we were all gamma-squeezed again, just in the opposite direction … a bubble rather than a crash. And again, whether we knew what gamma was or not.
I wrote this note about six weeks after that 2015 flash crash. My focus then was on systematic options trading and how the meaning of the options market has changed over the past 10-20 years. Today we’ve got a flood of decidedly non-systematic puppets retail options traders who have zero idea about any of this, together with large pools of capital (like SoftBank) who know how to pull these invisible threads to their advantage.
If you’re in public markets at all, you can’t disentangle yourself completely from these invisible threads.
But you can stop being a puppet.
Start by paying attention to the S&P 500 volatility term structure, and understand what it means…
These are both aerial photographs of Old Hickory Lake in Tennessee. On the left is a visible light photo in cloudy/hazy weather conditions, and on the right is an infrared light photo taken at the same time.
Almost all equity investors look at the stock market through a visible light camera.
[From the motion picture The Matrix]
|Morpheus:||Do you believe in fate, Neo?|
|Neo:||Because I don’t like the idea that I’m not in control of my life.|
|Morpheus:||I know *exactly* what you mean. Let me tell you why you’re here. You’re here because you know something. What you know you can’t explain, but you feel it. You’ve felt it your entire life, that there’s something wrong with the world. You don’t know what it is, but it’s there, like a splinter in your mind, driving you mad.|
|Cypher:||I know this steak doesn’t exist. I know that when I put it in my mouth, the Matrix is telling my brain that it is juicy and delicious. After nine years, you know what I realize? [Takes a bite of steak]|
|Cypher:||Ignorance is bliss.|
|Agent Smith:||Never send a human to do a machine’s job.|
A right-hand glove could be put on the left hand if it could be turned round in four-dimensional space.
– Ludwig Wittgenstein, “Tractatus Logico-Philosophicus” (1921)
I remember that I’m invisible and walk softly so as not awake the sleeping ones. Sometimes it is best not to awaken them; there are few things in the world as dangerous as sleepwalkers.
– Ralph Ellison, “Invisible Man” (1952)
Tell people there’s an invisible man in the sky who created the universe, and the vast majority will believe you. Tell them the paint is wet, and they have to touch it to be sure.
– George Carlin (1937 – 2008)
Invisible threads are the strongest ties.
– Friedrich Nietzsche (1844 – 1900)
This is the concluding Epsilon Theory note of a trilogy on coping with the Golden Age of the Central Banker, where a policy-driven bull market has combined with a machine-driven market structure to play you false. The first installment – “One MILLION Dollars” – took a trader’s perspective. The second – “Rounders” – was geared for investors. Today’s note digs into the dynamics of the machine-driven market structure, which gets far less attention than Fed monetary policy but is no less important, to identify what I think is an unrecognized structural risk facing both traders and investors here in the Brave New World of modern markets.
To understand that risk, we have to wrestle with the investment strategies that few of us see but all of us feel … strategies that traffic in the invisible threads of the market, like volatility and correlation and other derivative dimensions. A few weeks ago (“Season of the Glitch”) I wrote that “If you don’t already understand what, say, a gamma hedge is, then you have ZERO chance of successfully trading your portfolio in reaction to the daily ‘news’.” Actually, the problem is worse than that. Just as dark matter (which as the name implies can’t be seen with visible light or any other electromagnetic radiation, but is perceived only through its gravitational effects) makes up some enormous portion of the universe, so do “dark strategies”, invisible to the vast majority of investors, make up some enormous portion of modern markets. Perceiving these dark strategies isn’t just a nice-to-have ability for short-term or tactical portfolio adjustments, it’s a must-have perspective for understanding the basic structure of markets today. Regardless of what the Fed does or doesn’t do, regardless of how, when, or if a “lift-off” in rates occurs, answering questions like “does active portfolio management work today?” or “is now a good time or a bad time for discretionary portfolio managers?” is impossible if you ignore derivative market dimensions and the vast sums of capital that flow along these dimensions.
How vast? No one knows for sure. Like dark matter in astrophysics, we “see” these dark strategies primarily through their gravitational pull on obviously visible securities like stocks and bonds and their more commonly visible dimensions like price and volume. But three massive structural shifts over the past decade – the concentration of investable capital within mega-allocators, the development of powerful machine intelligences, and the explosion in derivative trading activity – provide enough circumstantial evidence to convince me that well more than half of daily trading activity in global capital markets originates within derivative dimension strategies, and that a significant percentage (if you held a gun to my head I’d say 10%) of global capital allocated to public markets finds its way into these strategies.
Let me stick with that last structural change – the explosive growth in derivative trading activity – as it provides the best connection to a specific dark strategy that we can use as a “teachable moment” in how these invisible market dimensions exert such a powerful force over every portfolio, like it or not. The chart on the right, courtesy of Nanex’s Eric Scott Hunsader, shows the daily volume of US equity and index option quotes (not trades, but quotes) since mid-2003. The red dots are daily observations and the blue line is a moving average. In 2004 we would consistently see 100,000 options quotes posted on US exchanges on any given day. In 2015 we can see as many as 18 billion quotes in a single day. Now obviously this options activity isn’t being generated by humans. There aren’t millions of fundamental analysts saying, “Gee, I think there’s an interesting catalyst for company XYZ that might happen in the next 30 days. Think I’ll buy myself a Dec. call option and see what happens.” These are machine-generated quotes from machine-driven strategies, almost all of which see the world on the human-invisible wavelength of volatility rather than the human-visible wavelength of price.
There’s one and only one reason why machine-driven options strategies have exploded in popularity over the past decade: they work. They satisfy the portfolio preference functions of mega-allocators with trillions of dollars in capital, and those allocators in turn pay lots of money to the quant managers and market makers who deliver the goods. But volatility, like love if you believe The Four Aces, is a many splendored thing. That is, there’s no single meaning that humans ascribe to the concept of volatility, so not only is the direct relationship between volatility and price variable, but so is the function that describes that relationship. The definition of gamma hasn’t changed, but its meaning has. And that’s a threat, both to guys who have been trading options for 20 years and to guys who wouldn’t know a straddle from a hole in the head.
Okay, Ben, you lost me. English, please?
The basic price relationship between a stock and its option is called delta. If the stock moves up in price by $2.00 and the option moves up in price by $1.00, then we say that the option has a delta of 0.5. All else being equal, the more in-the-money the option’s strike price, the higher the delta, and vice versa for out-of-the-money options. But that delta measurement only exists for a single point in time. As soon as the underlying stock price change is translated into an option price change via delta, a new delta needs to be calculated for any subsequent underlying stock price change. That change in delta – the delta of delta, if you will – is defined as gamma.
One basic options trading strategy is to be long gamma in order to delta hedge a market neutral portfolio. Let’s say you own 100 shares of the S&P 500 ETF, and let’s assume that an at-the-money put has a delta of 0.5 (pretty common for at-the-money options). So you could buy two at-the-money put contracts (each contract controlling 100 shares) to balance out your 100 share long position. At this point you are neutral on your overall market price exposure; so if the S&P 500 goes up by $1 your ETF is +$100 in value, but your puts are -$100, resulting in no profit and no loss. But the delta of your puts declined as your S&P ETF went up in price (the options are now slightly out-of-the-money), which means that you are no longer market neutral in your portfolio but are slightly long. To bring the portfolio back into a market neutral position you need to sell some of your ETF. Now let’s say that the S&P goes down by $2. You’ve rebalanced the portfolio to be market neutral, so you don’t lose any money on this market decline, but now the delta of your puts has gone up, so you need to buy some S&P ETF to bring it back into market neutral condition. Here’s the point: as the market goes back and forth, oscillating around that starting point, you are constantly buying the ETF low and selling it high without taking on market risk, pocketing cash all the way along.
There are a thousand variations on this basic delta hedging strategy, but what most of them have in common is that they eliminate the market risk that most of us live with on a daily basis in favor of isolating an invisible thread like gamma. It feels like free money while it works, which attracts a lot of smart guys (and even smarter machines) into the fray. And it can work for a long time, particularly so long as the majority of market participants and their capital are looking at the big hazy market rather than a thread that only you and your fellow cognoscenti can “see”.
But what we’re experiencing in these dark strategies today is the same structural evolution we saw in commodity market trading 20 or 30 years ago. In the beginning you have traders working their little delta hedging strategies and skinning dimes day after day. It’s a good life for the traders plucking their invisible thread, it’s their sole focus, and the peak rate of return from the strategy comes in this period. As more and larger participants get involved – first little hedge funds, then big multistrat hedge funds, then allocators directly – the preference function shifts from maximizing the rate of return in this solo pursuit and playing the Kelly criterion edge/odds game (read “Fortune’s Formula” by William Poundstone if you don’t know what this means) in favor of incorporating derivative dimension strategies as non-correlated return streams to achieve an overall portfolio target rate of return while hewing to a targeted volatility path. This is a VERY different animal than return growth rate maximization. To make matters even muddier, the natural masters of this turf – the bank prop desks – have been regulated out of existence.
It’s like poker in Las Vegas today versus poker in Las Vegas 20 years ago. The rules and the cards and the in-game behaviors haven’t changed a bit, but the players and the institutions are totally different, both in quantity and (more importantly) what they’re trying to get out of the game. Everyone involved in Las Vegas poker today – from the casinos to the pros to the whales to the dentist in town for a weekend convention – is playing a larger game. The casino is trying to maximize the overall resort take; the pro is trying to create a marketable brand; the whale is looking for a rush; the dentist is looking for a story to take home. There’s still real money to be won at every table every night, but the meaning of that money and that gameplay isn’t what it used to be back when it was eight off-duty blackjack dealers playing poker for blood night after night. And so it is with dark investment strategies. The meaning of gamma trading has changed over the past decade in exactly the same way that the meaning of Las Vegas poker has changed. And these things never go back to the way they were.
So why does this matter?
For traders managing these derivative strategies (and the multistrats and allocators who hire them), I think this structural evolution in market participant preference functions is a big part of why these strategies aren’t working as well for you as you thought they would. It’s not quite the same classic methodological problem as (over)fitting a model to a historical data set and then inevitably suffering disappointment when you take that model outside of the sample, but it’s close. My intuition (and right now it’s only intuition) is that the changing preference functions and, to a lesser extent, the larger sums at work are confounding the expectations you’d reasonably derive from an econometric analysis of historical data. Every econometric tool in the kit has at its foundation a bedrock assumption: hold preferences constant. Once you weaken that assumption, all of your confidence measures are shot.
For everyone, trader and investor and allocator alike, the explosive growth in both the number and purpose of dark strategy implementations creates the potential for highly crowded trades that most market participants will never see developing, and even those who are immersed in this sort of thing will often miss. The mini-Flash Crash of Monday, August 24th is a great example of this, as the prior Friday saw a record imbalance of short gamma exposure in the S&P 500 versus long gamma exposure. Why did this imbalance exist? I have no idea. It’s not like there’s a fundamental “reason” for creating exposure on one of these invisible threads that you’re going to read about in Barron’s. It’s probably the random aggregation of portfolio overlays by the biggest and best institutional investors in the world. But when that imbalance doesn’t get worked off on Friday, and when you have more bad news over the weekend, and when the VIX doesn’t price on Monday morning … you get the earthquake we all felt 6 weeks ago. For about 15 minutes the invisible gamma thread was cut, and everyone who was on the wrong side of that imbalance did what you always do when you’re suddenly adrift. You derisk. In this case, that means selling the underlying equities.
I can already hear the response of traditional investors: “Somebody should do something about those darn quants. Always breaking windows and making too much noise. Bunch of market hooligans, if you ask me. Fortunately I’m sitting here in my comfortable long-term perspective, and while the quants are annoying in the short-term they really don’t impact me.”
I think this sort of Statler and Waldorf [from the Muppets] attitude is a mistake for two reasons.
First, you can bet that whenever an earthquake like this happens, especially when it’s triggered by two invisible tectonic plates like put gamma and call gamma and then cascades through arcane geologies like options expiration dates and ETF pricing software, both the media and self-interested parties will begin a mad rush to find someone or something a tad bit more obvious to blame. This has to be presented in soundbite fashion, and there’s no need for a rifle when a shotgun will make more noise and scatters over more potential villains. So you end up getting every investment process that uses a computer – from high frequency trading to risk parity allocations to derivative hedges – all lumped together in one big shotgun blast. Never mind that HFT shops, for which I have no love, kept their machines running and provided liquidity into this mess throughout (and enjoyed their most profitable day in years as a result). Never mind that risk parity allocation strategies are at the complete opposite end of the fast-trading spectrum than HFTs, accounting for a few percent (at most!) of average daily trading in the afflicted securities. No, no … you use computers and math, so you must be part of the problem. This may be entertaining to the Statler and Waldorf crowd and help the CNBC ratings, but it’s the sort of easy prejudice and casual accusation that makes my skin crawl. It’s like saying that “the bankers” caused the Great Recession or that “the [insert political party here]” are evil. Give me a break.
Second, there’s absolutely a long-term impact on traditional buy-and-hold strategies from these dark strategies, because they largely determine the shape of the implied volatility curves for major indices, and those curves have never been more influential. Here’s an example of what I’m talking about showing the term structure for S&P 500 volatility prior to the October jobs report (“Last Week”), the following Monday (“Now”), and prior years as marked.
- The inverted curve of S&P 500 volatility prior to the jobs report is a tremendous signal of a potential reversal, which is exactly what we got on Friday. I don’t care what your investment time horizon is, that’s valuable information. Solid gold.
- Today’s volatility term structure indicates to me that mega-allocators are slightly less confident in the ability of the Powers That Be to hold things together in the long run than they were in October 2013 or 2014, but not dramatically less confident. The faith in central banks to save the day seems largely undiminished, despite all the Fed dithering and despite the breaking of the China growth story. What’s dramatic is the flatness of the curve the Monday after the jobs report, which suggests a generic expectation of more short-term shocks. Of course, that also provides lots of room (and profits) to sell the front end of the volatility curve and drive the S&P 500 up, which is exactly what’s happened over the past week. Why is this important for long-term investors? Because if you were wondering if the market rally since the October jobs report indicated that anything had changed on a fundamental level, here’s your answer. No.
- In exactly the same way that no US Treasury investor or allocator makes any sort of decision without taking a look at the UST term structure, I don’t think any major equity allocator is unaware of this SPX term structure. Yes, it’s something of a self-fulfilling prophecy or a house of mirrors or a feedback loop (choose your own analogy), as it’s these same mega-allocators that are establishing the volatility term structure in the first place, but that doesn’t make its influence any less real. If you’re considering any sort of adjustment to your traditional stock portfolio (and I don’t care how long you say your long-term perspective is … if you’re invested in public markets you’re always thinking about making a change), you should be looking at these volatility term structures, too. At the very least you should understand what these curves mean.
I suppose that’s the big message in this note, that you’re doing yourself a disservice if you don’t have a basic working knowledge of what, say, a volatility surface means. I’m not saying that we all have to become volatility traders to survive in the market jungle today, any more than we all have to become game theorists to avoid being the sucker at the Fed’s communication policy table. And if you want to remove yourself as much as possible from the machines, then find a niche in the public markets where dark strategies have little sway. Muni bonds, say, or MLPs. The machines will find you eventually, but for now you’re safe. But if you’re a traditional investor whose sandbox includes big markets like the S&P 500, then you’re only disadvantaging yourself by ignoring this stuff.
Ignorance is not bliss, and I say that with great empathy for Cypher’s exhaustion after 9 years on the Matrix battlefield. After all, we’ve now endured more than 9 years on the ZIRP battlefield. Nor am I suggesting that anyone fight the Fed, much less fight the machine intelligences that dominate market structure and its invisible threads. Not only will you lose both fights, but neither is an adversary that deserves “fighting”. At the same time, though, I also think it’s crazy to ignore or blindly trust the Fed and the machine intelligences. The only way I know to maintain that independence of thought, to reject the Cypher that lives in all of us … is to identify the invisible threads that enmesh us, some woven by machines and some by politicians, and start disentangling ourselves. That’s what Epsilon Theory is all about, and I hope you find it useful.
PDF Download (Paid Membership Required): Invisible Threads – Matrix Edition
I’ve been reading Ben for years. He has a Ph.D. from Harvard and taught political science for ten years before entering the investment business. He started in venture capital, was a long/short hedge fund manager and joined Salient Partners as a portfolio manager in 2013.
I meet Ben in 2018 for a coffee with John Mauldin. We became friends while fishing at Camp Kotok’s annual Shadow Fed get together in Maine.
You can follow Ben on Twitter @EpsilonTheory and he also offers a subscription service which I recommend.
September 9, 2020
S&P 500 Index — 3,580
Notable this week:
With a short, one-week stint on the sell side, the Zweig Bond Model is back to a buy signal. Noted. High yield moved to a sell signal yesterday; however, the Fed likely sits ready to support the downside. We’ll keep close watch. The balance of the equity trend signals remain bullish. The weight of evidence measured across sectors, by my favorite equity trend indicator, the Ned Davis Research CMG US Large Cap Long/Flat model, continues to show strong price strength. Bullish optimism took a slight hit after the September sell off. It remains too bullish. Gold remains in an uptrend buy signal.
A couple fun tweet screen captures this week… hope you like them:
Well, maybe that wasn’t so fun. Risk remains extremely high. Keep stops set firmly in place.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
“Right now people you know are dealing with stuff you know nothing about.
Look for opportunities to support, encourage, and be kind to others.”
– Jon Gordon, Author and Speaker
I woke this morning and read David Kotok’s 9/11 email. I paused. I cried. I prayed.
I’m sure you remember exactly where you were that awful day. I lost friends, and I’m sure you did too.
NFL football season kicked off last night. The Super Bowl champions, the Kansas City Chiefs, beat Houston 34 to 20. Exhausted, I didn’t even make it to halftime. I’m glad it’s here. And the English Premier League 2020/2021 season starts tomorrow. I’ll have computer on lap, coffee in hand, and in front of my favorite TV (7:30 am).
The weekend weather here in Philadelphia looks amazing. Mid-70s. Golf is on the schedule tomorrow with daughter Brianna and one of her co-workers. That will be fun. And my Eagles are home this Sunday facing Washington at 1:00 pm ET. Maybe some morning golf with my buddies and an afternoon on the couch with the computer, a cold IPA, and the remote control. Go Birds!
Susan will be away coaching her teams both Saturday and Sunday. Don’t tell her, but all her coaching is really helping my golf game. And speaking of coaching, a long-time OMR reader sent me a very nice note. Please indulge me one last moment for a quick story.
I thought you & Susan might enjoy this article about a soccer coach.
By the way, I got my MBA in finance at UChicago 45 years ago, where I had future Nobel laureates like Eugene Fama, Myron Scholes, and Merton Miller as professors.
The article features the story of Len Oliver, who earned his Ph.D. at the University of Chicago in 1970 and went on to become a coach’s coach. He had been a great player himself. The son of a Scottish immigrant, he and his twin brother, Jim, followed in their father’s footsteps and grew up playing soccer—then largely considered an immigrants’ game—in Philadelphia. A midfielder, Len was an alternate for the 1952 Olympics in Helsinki and hoped to make the 1956 team. He’s retired now and living in the DC area. My favorite part of the article discussed his relationship with his two grandchildren, who play soccer and call him Coach. “I just melt,” he says. “I’d rather be called Coach than Dr.”
I wrote back to Calvin that I’m sure Len Oliver was a friend of my college coach, Walter Bahr. Of course, we always simply called him “Coach.” Oh, the many lessons learned on the field. We are individuals but, in the game, we are a team.
In 1979, on a cold late November day, our young Penn State team beat powerhouse Indiana University 2-0 to advance to the NCAA final-four soccer tournament in Tampa, Florida. In the semi-final game against SIU Edwardsville, we trailed 1-0, but we felt the game was ours. We dominated the second half, outshot SIU, and with less than five minutes to play, put a third shot off their cross bar. SIU countered and scored on a 40-yard knuckle ball shot to the upper right corner. Less than two minutes remained. Even today, I can see that goal pass the outstretched fingers of our goalie as clear as day. We lost 2-1. We went on to win the consolation game against Columbia University. SIU beat Clemson 3-2 to win the National Championship.
That’s the closest Penn State came to a National Championship. Coach Bahr won Coach of the Year and our superstar striker, Jim Stamatis, won the Hermann Trophy (soccer’s equivalent of the Heisman Trophy).
In 1958, Coach Bahr led the U.S. National Team to a 1-0 victory against England in the World Cup in Brazil. There is a movie about the team called The Game of Their Lives.
In 1979, I was thinking about me. I had no idea who Coach really was. Shame on me. By 1983, my senior year, I was a bit wiser because of Coach. And his teachings mean even more to me today.
Great coaches coach teams. Great teams require different skillsets and the willingness to work together. “Together, we are strong.” Let’s stay together even when we think differently!
I really do believe we have to come together as a team. Together, we get better answers. Together, we win.
Call an old coach and let her know you are thinking about her. Or him. And call an old teammate too. If you didn’t play sports, reach out to your favorite teacher. These are challenging times. A little kindness, like a stone thrown into a still pond, sets a ripple in motion.
Thanks for indulging me. Wishing you a wonderful week.
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
IMPORTANT DISCLOSURE INFORMATION
Investing involves risk. Past performance does not guarantee or indicate future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc. or any of its related entities (collectively “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
Certain portions of the content may contain a discussion of, and/or provide access to, opinions and/or recommendations of CMG (and those of other investment and non-investment professionals) as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current recommendations or opinions. Derivatives and options strategies are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from CMG or the professional advisors of your choosing. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing. CMG is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.
This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, by any CMG client from any specific funds or securities. Please note: In the event that CMG references performance results for an actual CMG portfolio, the results are reported net of advisory fees and inclusive of dividends. The performance referenced is that as determined and/or provided directly by the referenced funds and/or publishers, have not been independently verified, and do not reflect the performance of any specific CMG client. CMG clients may have experienced materially different performance based upon various factors during the corresponding time periods. See in links provided citing limitations of hypothetical back-tested information. Past performance cannot predict or guarantee future performance. Not a recommendation to buy or sell. Please talk to your advisor.
Information herein has been obtained from sources believed to be reliable, but we do not warrant its accuracy. This document is a general communication and is provided for informational and/or educational purposes only. None of the content should be viewed as a suggestion that you take or refrain from taking any action nor as a recommendation for any specific investment product, strategy, or other such purpose.
In a rising interest rate environment, the value of fixed income securities generally declines and conversely, in a falling interest rate environment, the value of fixed income securities generally increases. High-yield securities may be subject to heightened market, interest rate or credit risk and should not be purchased solely because of the stated yield. Ratings are measured on a scale that ranges from AAA or Aaa (highest) to D or C (lowest). Investment-grade investments are those rated from highest down to BBB- or Baa3.
NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE.
Certain information contained herein has been obtained from third-party sources believed to be reliable, but we cannot guarantee its accuracy or completeness.
In the event that there has been a change in an individual’s investment objective or financial situation, he/she is encouraged to consult with his/her investment professional.
Written Disclosure Statement. CMG is an SEC-registered investment adviser located in Malvern, Pennsylvania. Stephen B. Blumenthal is CMG’s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy, or exclusively determines any internal strategy employed by CMG. A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at www.cmgwealth.com/disclosures. CMG is committed to protecting your personal information. Click here to review CMG’s privacy policies.