Remember all those bullish studies market pundits were passing around in early January? Do you recall the parroting about “how goes January, the rest of the year follows?” It’s easy to forget, but many market strategists were falling all over themselves bullish just a couple of weeks ago (see Parabolic Moves Don’t End by Going Sideways).
Now, some 300 handles lower in the S&P 500, many of these same forecasters are talking about the extensive technical damage and advocating caution.
I am not here to pick on any pundits - I subscribe to the Yogi Berra school of forecasting - it’s tough to make predictions, especially about the future. But I take issue with one major aspect of the current investing environment. Most market players are using the playbook from the last few decades in their forecasts. They are mistakenly thinking the rules of the game haven’t changed.
Their predictions from last month are still ringing in my ears; low volatility January rises have been followed with stock market strength, so there’s no way anyone could predict that stocks would swoon 10% in a week and a half for no real reason at all. Yet that’s exactly what they did.
What’s different today?
I find myself hesitant to type out these next few lines. As I struggle to find the words to communicate my thoughts, I worry they will be misconstrued. Yet I don’t know how else to say it - except to blurt it out. So at the risk of being labeled a fool, here it goes - it’s different this time.
Yup. I said it. I committed the cardinal sin of investing. I uttered the most expensive four words in the history of markets.
Before you call me a Luddite and hit delete on your email or click the home button on your browser, hear me out.
I am all too aware that Jesse Livermore was spot on correct when he said, “I learned early that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”
In the big picture, the game never changes. There will be early shrewd veterans who get in early. There will be overly eager fools who stay in too late. The players won’t change. The end result will always be the same.
Yet, the circumstances surrounding the game are always different. In 1987 it was portfolio insurance. The turn of the century saw the DotCom bubble. Then in 2008, the credit crisis surprised everyone with the most violent risk asset sell-off in a hundred years.
There are plenty of market strategists who believe they know the cause of the next crisis. Although I have my own theories, I am not nearly as confident as most of these other pundits.
And neither am I suggesting that you blindly close your eyes and continue to be long financial assets because the rise seems unstoppable. No, far from it. I am petrified about how our financial system has been distorted with quantitative easing and negative rates.
But I suggest that anyone who claims to know how this financial science experiment ends is kidding themselves.
Look at the actions of the Central Banks over the past decade.
Do any strategists really know what a Swiss National Bank balance sheet of 126% of GDP with a big slug of foreign equities means for both the economy and the markets? Or how about a Bank of Japan, the world’s 3rd largest economy, expanding their balance sheet from 35% to 97% of GDP in the space of five years? And can any forecaster say with any confidence what these Central Bankers will do in the future? Will the Federal Reserve actually be able to follow through with their quantitative tightening? Will the Bank of Japan ever stop printing? Do we have any confidence that the ECB is anywhere close to tapering their QE? Sure, we can all guess, but let’s face it - few ever guessed we would be here today, so why does anyone think they will be able to predict where we will be in the future?
No - if someone tells you they know how the current environment ends, show them the door. Central Bankers have changed the game, and we have never been here before. Let me repeat that part. We have never been here before.
When the Great Credit Cycle ended, Central Banks stepped in to fill the void left from the private sector in terms of credit creation and we entered a new era in the history of financial markets. And the direction this new path will take us is extremely difficult to determine.
Will Central Bankers ever be able to wind down their balance sheet? Will they even try? What will happen if inflation takes off? Even worse, what if deflation kicks in? I don’t know how Central Bankers will react, and neither does anyone else. Yet unfortunately these questions need to be answered to be able to forecast with any accuracy.
Last week shouldn’t be a surprise
Many market participants were bewildered by last week’s out-of-the-blue sell-off.
Articles like MarketWatch’s “What’s really to blame for the sudden shattering of the stock market’s calm?” desperately try to assign a reason for the seemingly inexplicable market action. Rising yields, volatility products, greed, algos, inflation - all decent guesses, but they are just that - guesses.
The truth of the matter is that the nature of the markets has changed. Not only has the actual market structure changed with the predominance of VWAP and TWAP orders, but the bigger problem is that Central Banks have made a mockery of financial markets. How are you supposed to value risk assets when Central Banks are actively monetizing their balance sheet against foreign equities?
January’s rise was a farce. The incessant march higher was something we had never seen. We broke all sorts of records in regards to the lack of variance during that rally. Sure it felt great for the bulls, but it was far from natural. And so it should come as no surprise when February’s swoon was just as unusual.
Markets have changed. You can sit and bemoan this new reality, or even worse, you can take a religious view that stocks are heading in one direction, and then use whatever market action affirms your theory and shout it from the rooftops on the days when it works, and complain about the rigged markets on the days it doesn’t.
Personally, I am trying to avoid the dogmatism and stay open minded.
But make no mistake, the game has changed. Be extremely wary of any sort of stat that says so-and-so has never happened. Central Bank balance sheet expansion and negative rates have forever changed the financial system. Adapt to it. Take heed of that advice from every prospectus, broker statement and fund presentation - past performance is no guarantee of future results. That’s always applicable. And never more so than today.
Why did we rip higher Friday?
Friday morning’s stock market action was ugly. Spooz were offered, and broke all sorts of support in a sickening swoon. Yet just as things looked as if they were about to cascade to the downside, a face ripping rally rocketed the S&P 500 higher, finishing up on the day.
By now everyone is familiar with the XIV fiasco (One of the Greatest Squeezes of All Time?), but even though that short volatility exposure has disappeared with the collapse of XIV and other ETNs, there are many more short volatility strategies that still have exposure.
Have a read through of this article from CNBC:
The e-mail arrived in clients’ inboxes shortly after the market opened on Tuesday: “LJM strategies have suffered significant losses.”
LJM Partners, a Chicago-based hedge fund with about half a billion dollars in assets, pinpointed the damage on spiking volatility, a trade that has claimed more than one scalp in the last few trading days. Their mutual fund, known as the LJM Preservation and Growth Fund, collapsed by 82 percent over the last week and was closed to new capital on Wednesday.
Investors in the industry are calling LJM among the most prominent funds to fall victim to the popular “short vol trade.” The trade had become profitable for many hedge funds, including LJM, whose “Preservation and Growth” fund posted positive returns every year except one since it launched in 2006, according to fund documents.
Tuesday’s client note, signed by LJM’s Founder and Chairman Tony Caine, said that the portfolio management team has been hedging “with as many futures as possible to attempt to insulate portfolios from further losses.” He caveated that their “ability to do so depends on market conditions and liquidity.”
“Our goal is to preserve as much capital as possible,” he said.
LJM did not respond to multiple requests for comment.
The firm sent a note last Friday, describing the specific aspects of their portfolio that created losses in the month of January - before the market turmoil of this past week. Even still, rumblings in volatility during just the first month of the year caused losses in each of their three strategies.
“A rapidly rising market coupled with volatility at this magnitude is a rare market occurrence and is particularly challenging to the LJM strategy,” the firm wrote to clients, according to a letter reviewed by CNBC. “Since the LJM strategies provide exposure to volatility, the strongest headwind came from the sharp rise in volatility and accounted for most of our losses in January.”
I highlighted the important part of this article. LJM’s founder Tony Caine was shorting “as many futures as possible to attempt to insulate portfolios from further losses.” This is what we call chasing gamma. And he was by no means alone. As the markets collapsed, the options that volatility sellers had shorted became increasingly likely to finish in the money, so they were forced to short stocks to hedge that risk.
But the problem doesn’t go away simply because they hedged their delta. What do you think is the result if the stock market rallies? Well, as the put options they just hedged become less likely to finish in the money, LJM and all the other gamma chasers need to buy back their short position.
This market chasing doesn’t disappear until their options expire (or the market moves so far away that it is almost completely certain to finish either in or out of the money).
Of course, it is way more complicated than this. There are different ways to short volatility. Variance swaps, VIX products, all sorts of different strategies involving all sorts of different products - but at their heart, if you short volatility, you are short gamma, and unless you just let it all ride, you are forced to chase the market as it zips around.
And this is the important point. Although volatility most often rises in down markets, it doesn’t always have to be that way.
On October 15th, 1998, Alan Greenspan surprised the stock market with an inter-meeting special 25 basis point cut. This was the Thursday before Friday’s option expiry. Some tin-foil-hat-wearing financial types believe that Greenspan chose this day on purpose to give him the greatest bang for the buck.
You see, all the calls that were about to expire out-of-the-money suddenly needed to be hedged as markets ripped higher by more than 5%.
Now you might say, wait - what if market makers were long those call options and hedged them on the way up? In that case, they would be slowing the rise, not contributing to it. And that would be correct.
As the market zips around, to determine what the effect will be on the market, it’s important to understand who is long the volatility and who is short. For every option trade, there is a buyer and seller. Their reactions will differ based on their timeframe and risk tolerance.
But there is no doubt that all this recent volatility selling of the past few years has attracted too much capital that is ill-equipped to simply weathering the drawdowns. Funds like LJM will be hedging. And that hedging will not be solely one way. Until their exposure expires, they will be forced to chase around the markets - both to the downside, but also to the upside.