Ever since a few far-sighted, contrarian traders made a killing by betting on the collapse of subprime in 2005 and 2006 - and by implication on the implosion of the capital markets - a trade famously resurrected in the latest Wall Street movie The Big Short (whose Michael Burry recently warned that "The Little Guy Will Pay" For The Next Crisis [19], again) everyone has been dreaming to uncover the next "subprime" - a trade that has a 20-to-1 upside to downside ratio, which can be put on in massive size, and which would lead to a quick and lucrative retirement.
So far the next "subprime trade" remains elusive, with global capital markets continuing to grind ever higher thanks to constant central bank manipulation, as first called out on this website many years ago, and as admitted recently even by such "serious" legacy institutions banks as Bank of America which in an attempt to explain market instability
Central bank’s risk manipulation well explains local tails
A good way to explain why we have seen local tail risks arise so frequently since central banks began to heavily manipulate asset prices is with the following analogy, illustrated in Exhibit 1. Essentially central banks, by unfairly inflating asset prices have compressed risk like a spring to unfairly tight levels. Unfortunately, the market is aware the price of risk is not correct, but they can’t fight it, and everyone is forced to crowd into the same trade. By manipulating markets they have also reduced investors’ inherent conviction by rendering fundamentals less relevant.
This then creates a highly unstable (fragile) situation that breaks violently when a sufficient catalyst causes risk to rise – overly crowded positioning meets a market with little conviction.
The above explanation leads to a critical line of thought: perhaps the next "subprime" trade is not shorting a mispriced asset at all?
After all, all assets are mispriced as a result of central bank intervention.
As BofA admits "the market is aware the price of risk is not correct, but they can’t fight it, and everyone is forced to crowd into the same trade", which is logical: after all why should one fight the Fed when any time there is even a 5% drop in the S&P500, the Fed can and will either jawbone and threaten to cut rates or launch QE4 or NIRP, or just do it? In doing so, of course, the Fed merely "kicks the can" and with every failed attempt at reprice risk and bring back some trace of price discovery, guarantees that the next market crash will be the most epic ever, one which will wipe out not only the Fed's credibility but the bedrock of the modern financial and economic system, a monetarist system based on neo-Keynesian rules. Frankly, the devastation can not come fast enough.
But first, why not make some money?
And if one is limited from generating 20-1 returns in a market of suppressed volatility due to a global central bank puts, perhaps the next "subprime" trade has to do with the process of actually putting the trade on.
A process which involves ETFs.
To be sure, we - and many others - had issued many warnings about the very nature of ETFs in recent years, especially during 2015. Here is a brief chronology of the countless warnings we have issued on this topic in the past year alone:
- March 2015: What Would Happen If ETF Holders Sold All At Once? Howard Marks Explains [20]
- May 2015: ETF Issuers Quietly Prepare For "Market Meltdown" With Billions In Emergency Liquidity [21]
- June 2015: How Fund Managers Use ETF Phantom Liquidity To Avert A Meltdown [22]
- July 2015: The Complete Guide To ETF Phantom Liquidity [23]
All of these warnings became realized on August 24, the day of the infamous ETFlash Crash which even the SEC remarked on in the last week of December with an 88-page note on "Equity Market Volatility on August 24, 2015 [24]." What the SEC essentially said is that it is generally concerned with plumbing and exchange regulation, with an emphasis on ETFs.
To be sure the story of broken markets as a result of the epic proliferation of Exchange Traded Funds continued after August, with stories such as:
- August 2015: Was Monday's ETF Collapse Just A Warmup? [25]
- September 2015: Mom And Pop "Will Probably Get Trampled": Alliance Bernstein Warns On Bond ETF Armageddon [26]
- October 2015: How The Entire Short Volatility ETF Complex Could Be Wiped Out Overnight [27]
- November 2015: How Illiquid Are Bond ETFs, Really? (Spoiler Alert: Very!) [28]
Is it possible that "the next subprime trade" was so obvious that it was staring everyone in the face for the past year?
A trade which involved betting on the collapse not of the central-bank supported market, but the death of the instrument which allows this unprecedented global central bank "put" to prop up markets, and which like the infamous coiled spring in the Bank of America "revelation [29]" is just waiting for a catalyst to snap: in other words, betting against ETFs?
Actually the answer is yes, and for some, the "next subprime trade" is already happening.
Meet David Miller and his Catalyst Macro Strategist Fund (ticker: MCXCX). The introduction, provided by WaPo [30]reads like something straight out of a Michael Lewis book:
The Michigan-native is betting against one of the most popular investment vehicles for mom-and-pop investors: exchange-traded funds. The bets have paid off, turning Miller’s little known Catalyst Mutual Funds into one of Wall Street’s most successful players in 2015.
It sure sounds like a story about one of the lucky few who correctly predicted in 2006 what would happen to not just subprime, but the overall market just a few years later... and would retired filthy rich.
The comparisons between Miller's story and the "Michael Burry's" of the subprime era don't end there, because the young asset manager has not only figured out what to bet against, but how to make a lot of money in the process: ever since it started making complicated bets against some leveraged ETFs, Miller’s Catalyst Macro Strategies Funds has since grown from $500,000 in assets at the start of the year to about $170 [31] million. It achieved a more than 50 percent return this year, placing it far ahead of its competitors.
In a year in which virtually not one hedge fund generated notable returns, and most were an embarrassment, it is surprising that not all financial media outlets are talking about Catalyst's performance, which as shown below, is quite impressive. Behold the 2015 performance of the Catalyst Macro Strategy Fund, which according to Morningstar [31]held a total of $169.5 million in assets most recently.
[32]
Miller's initial target in the broken sector: leveraged ETFs: "Our goal is to identify poorly designed financial vehicles,” said Miller, Catalyst’s senior portfolio manager. “The strategy has certainly worked out well for us."
While still a tiny part of the market, the growth of leveraged ETFs has been explosive. Nearly nonexistent in 2005, the market has grown to more than $20 billion this year, according to data from Lipper. The market has doubled since 2011.
The regulators have, as usual, been asleep at the wheel, making such debacles as August 24 a recurring reality, and allowing people like Miller to make outrageous profits by betting against the broken market:
[A]s the industry has grown, so have concerns around whether investors understand the risks. The Securities and Exchange Commission proposed rules in December to rein in these type of funds. And the Financial Industry Regulatory Authority, also known as FINRA, has cracked down on brokers who have sold complicated ETFs they didn’t understand.
“The SEC and FINRA have been coming down on them, and they still have not gone away,” Miller said. “Money keeps coming into them despite their poor performance.”
But if leveraged ETFs are the "BBB" CDO tranches in the subprime analogy, then regular, and just as broken ETFs, will be the A, AAs and higher which will be the next to flame out: "Even traditional ETFs aren’t immune from market volatility. Over the summer, the price of some ETFs dropped off a cliff, then bounced back within minutes. Investors who automatically sold as their value plunged, faced heavy losses."
Catalyst may have been the first, but many more are coming, looking to profit from problematic ETFs. New York hedge fund Hilltop Park has employed complicated trades to bet against some ETFs, according to The Wall Street Journal [33].
Perhaps the final analogy to the subprime crisis is the infamous straw that broke the camel's back: back then, just like now, the fulcrum security was safe... until enough bets had been made against it (infamously by such as Goldman itself, which via Abacus and others, was selling exposure to CDOs only to short them at the same time), at which point the bubble bursts.
And while 10 years ago it was the subprime bubble, this time it will be the ETFs that go first as more and more bets against them proliferate, and when they do, it will be all up to the central banks to preserve the last artificial asset prices in "markets" which over the past eight years forgot how to discount reality, and merely reflect the intentions of a few clueless economist hacks.
To help accelerate this process, we present Catalyst Macro Strategy's latest prospectus [34], with hopes more modern "Michael Burrys" emerge and take on what the fulcrum security of today's broken markets.
