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"When The Market Moves Fast, Stuff Blows Up"
Authored by 10th Man's Jared Dillian, originally posted at Mauldin Economics,
One of my old rules of trading is that whenever a major asset class, index, or other benchmark has a sudden, rapid move in price, something blows up. Sky high.
That’s because people get used to regimes. They get used to a certain state of affairs with a lack of volatility. They become complacent. Maybe they stop hedging. Maybe they allow themselves to have unbounded downside risk. Maybe they start gambling.
In the last month, we’ve seen massive moves in the dollar and oil—and I assure you, someone is going to get hurt.
So far I haven’t said anything controversial. Energy companies are going to get hurt by lower oil prices. Exporters are going to get hurt by a rising dollar. A chimpanzee could figure this out.
But there are second-order effects. People are starting to figure out that Canadian banks are going to get hurt by the lack of investment banking business from the energy sector, and the stocks are getting punished.
And there are third-order effects too, which people will soon discover.
If you sit around and think hard enough, you can make these sorts of connections. Some people are very good at this. A commodity price moves fast, and they can figure out the point of maximum pain for some company far down the supply chain from the actual commodity.
I’m not that smart. But I’m smart enough to get out of the way when something big and important like oil moves 40%.
Let’s step into our time machine and set the dial to 1994. That was the year when interest rates backed up a couple of percentage points. Remember the bond market vigilantes? They were pricing in Hillarycare and a Democratic Party wish list, and they caned the bond market until interest rates were making borrowers squeal.
But what was interesting about 1994 was that in the grand scheme of things, interest rates didn’t go up all that much. Just a couple of percentage points. Now, if I asked you who you thought would get hurt by rising rates, you might say banks, hedge funds. And you would be wrong. Who got hurt by rising interest rates?
- Procter & Gamble.
- Orange County, CA.
- Mexico.
Why did the first two blow up? Derivatives.
By the way, I’m not referring to derivatives pejoratively. I’ve spent most of my adult life trading them. They’re not financial weapons of mass destruction. What they do is take risk over here and move it over there. So if bank XYZ was negatively exposed to higher interest rates, they were able to offset that exposure to Orange County through derivatives.
Of course, the derivatives Orange County was trading were very exotic and clearly unsuitable for a municipality, but that’s a discussion for another time over a burger and a beer. The point is that rates moved, and they moved fast, and stuff blew up.
But not the stuff you thought would blow up.
Buying Volatility on the Cheap
So I know what you’re going to ask me next: What’s going to blow up?
Who knows? By definition, you can’t know, especially when the risk has been laid off through derivatives.
But this is how it works: Oil moves 40%, the dollar moves 10-15%, and someone’s out of business. It could be someone big. It could be someone systemically important, someone that could really spook the markets. So when stuff like this happens, I get myself exposure to things that gain from disorder (paraphrasing Black Swan author Nassim Taleb).
With the S&P 500 Index (SPX) at 2,050 and the CBOE’s Volatility Index (VIX) at about 15, systemic risk is vastly underpriced.
I’m not saying that stocks are too high, that I’m bearish. I’m just saying that the derivatives markets aren’t pricing in what could be a big unwind based on these oil and dollar moves.
Translation: volatility is cheap.
Is $60 oil bullish for stocks, long term? Absolutely. It is one of the most bullish things I can think of. One of my clients recently told me that this decline in oil will result in $100,000 in annual fuel savings for his business. Multiply that times everyone. So bullish. And the dollar, also long-term bullish. But in the short term, there’s an Amaranth out there somewhere, potentially.
Maybe it’s not a hedge fund. Maybe it’s a company like Coca-Cola (KO) that gets the majority of its earnings from overseas. Maybe it’s the railroads. The person who can figure this out wins the prize.
As I said before, I’m not that smart… just a former trader with scabs on his knuckles. But the funny thing about those traders—especially the ones over 40—is they have a nose for trouble. I’m all in favor of bullish developments, just not when they happen really fast and nobody is ready, which is how people get maimed.
Position: long three-month SPY puts, short Canadian Imperial Bank of Commerce (CM) and Toronto-Dominion Bank (TD) (the US-listed shares).
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"Is $60 oil bullish for stocks, long term? Absolutely. It is one of the most bullish things I can think of. One of my clients recently told me that this decline in oil will result in $100,000 in annual fuel savings for his business."
Is $150 billion in junk bond defaults for shale companies also bullish?
Some good vibes for evening:
https://soundcloud.com/olav-nurk-1/black-diamond
ilion, this is off topic. Although the guy has some talent.
wait wait, I got this...
If you have a time machine, why would you dial it back to 1994 when you can dial it to the future and get valuable info, like what will happen in the next season of the Kardashians.
I call build a bear dead...
BS 40% of the S&P is exposed here
Or the darkness
https://www.youtube.com/watch?v=IcHCaudvyN0
Equities look to be going out negative: no short-covering or knife catching in sight.
I see a "Rampjob: FAIL" developing...
No way they carry this BS into the weekend. Friday dump coming up.
Santa just needs to sell some holdings to buy toys?
But really, the ramp was weak, where in sometimes the pullbacks are rather strong. THe overall last ramp was pretty powerful and profit is getting taken.
http://screencast.com/t/0YueVX9Q
Sorry for those who don't understand this goofy shit, but is the life of the stock operator.
Absolutely. And it's also time to cue the "price pressure due to year end tax selling" articles. I'm kind of surprise Market Watch didn't post one after yesterday.
We blew some folks
We mutilated some donkeys.
What's happening right now in the "markets" is already fun to watch. Can't wait for shit to get real...
Low liquidity around Christmas time will be fun, nothing says merry Christmas like "Margin Call, ho, ho ho!"
If the world should blow itself up, the last audible voice would be that of an expert saying it cant be done.
No one ever expects the Inquisition.
What happened to the smash-up? They are all running for the exit....
Bad moon rising tomorrow
Only 2 minutes left to short gld and miners before tomorrow's crash.
TVIX up 25% since noon
FAZ me...
www.faz.net :)
Regarding derivatives: "They’re not financial weapons of mass destruction. What they do is take risk over here and move it over there." Nobel regretted inventing TNT; someone gets hurt, you're shuffling dynamite but it's o.k. if you don't see the dead people?
Regarding Amaranth: In English "Amaranth" is either a plant of the species Amaranthus or a reference to an imaginary flower that never fades; sounds like you meant "wilt" or "fade".
This might help (although I suspect you already know this):
http://en.wikipedia.org/wiki/Amaranth_Advisors
Thanks for that; a $5 Billion loss in Natural Gas futures, ouch!
Yeah, there's an "Amaranth" or two out there in this oil price plunge.
It is a good article, although when I read it and posted the link in the Crude oil thread, I had the same thought on derivatives, moving them around doesn't make them go away...
DaddyO
Agreed. And the author says: "Maybe they allow themselves to have unbounded downside risk. Maybe they start gambling."
Then he goes on to defend derivatives, as if that isn't gambling.
Funny how gamblers always defend their addiction: "I'm not betting on horse races sweetheart, I'm an equine performance evaluator." *cough*
Tomorrow might be interesting
...if you enjoy watching the S&P open down 7 points and then drift higher all day.
THAT is some funny shit, Al. Add in the fact that there are only "2 shopping weekends until Xmas" and we're going to see some seasonal green to go with the splash of red. Next thing you see that's red will be Rudolf's nose, not some Greenwich hedgie with his asshole on fire.
"as STA Wealth Management's Lance Roberts points out,November's seasonal adjustment for retail sales was - drum roll please - the 3rd largest on record..."
it evens out ... sorta ... when you mix with december
to get adjusted number you divide the unadjusted by the seasonal factor
2013 seasonal adjustments
november ... 1.005
december ... 1.128
2014 seasonal adjustments
november ... .988
december ... 1.143
december takes away what november brought ... bullz better pray for a good unadjusted number ... they'll need it.
http://www.census.gov/retail/marts/www/download/text/adv44x72.txt
Where's your server room mr. Durden? I need to get closer due to High Frequency Reading.
It's Bush's Fault! ...or maybe Warren Buffet's....
As long as the printing presses work and the PPT is active, volatiliy is a fools game IMO. The next crisis will be a currency crisis, one that is beyond the control of the FED, the BIS, the IMF, the PPT et al. Until then, the shenanigans will relentlessly continue.
But it's the PM markets aren't allowed to move too fast, as of late this afternoon. This is pretty fucking interesting:
http://www.tfmetalsreport.com/blog/6443/comex-institutes-trading-collars...
" Maybe they stop hedging" I hate to break it to those who believe that hedging removes risk, they are wrong, they MOVE risk. All the hedges absolutely must have a counter party to take the other side of the bet, they are the money who makes good the hedged bet.
So, the blow up still happens! It happens to someone else. Remember 2008?? Sometimes the other side of the Hedged Bet hasn't got the money to make good their end of the deal! Remember 2008 when the hedges blew up?
The word Hedge is just too over used and too over rated. It seems, by it's very nature to break the laws of physics. You can go bust on one trade, but your hedge will make it good, and all is well in the world. WRONG! The other side of the bet may not be able to make good their hedge obligations, like 2008. Physical law will not be broken, if there is a loss, a real loss, in markets, SOMEONE, sooner or later will be obligated to make it good. And, like 2008, they won't have the money to meet it!
Deutsche Bank is one side of trillions in hedges. If some of those bets get called in, does anyone think Deutsche Bank can pay them off? No, of course not. So then, what does the word "I am hedged" really mean? For it to mean anything at all, you must KNOW your counter party can and will make good their side of the bet should it be called in.
Silver had a major move in price and nothing else blew up.