The Pain Trade is (slowly) Higher

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The theme of crowded trades going the “wrong way” from 2018 continues in 2019. As we have been pointing out, extreme positioning has been one of the main drivers in recent moves across assets. Given the sudden change in sentiment that started back in October, most investors have been caught wrong. Portfolio managers usually don’t react as quickly as short-term traders. This leads to reshuffling of portfolio risks many times after the big moves have occurred.

Below chart shows the CTA index (top hedge funds that deploy a “model” type of strategies, white) versus the SPX (orange). The model funds used to move in tandem with the SPX, but “switched” direction bias in early December. As the SPX was falling hard in December, the CTA space gained. Note how this has reversed since the SPX started bouncing around Christmas.

The crowd is getting squeezed and the pain trade remains a move higher in equities.

 

But sentiment is so bad and the TRADPAUS index has collapsed!

Yes, this is very true, but as we have been pointing out since mid-December, extreme low readings in the TRADPAUS often marks local lows in the SPX. This is the very definition of the negative sentiment investor that is late to the party. Note the local extreme lows in the TRADPAUS and violent bounces in the SPX back in 2015/16.

 

 

Volatility is a very misunderstood asset by the crowd. The average investor buys hedges at wrong times and tends to overpay for protection. Instead of buying the insurance on the house before the house burns down, they tend to buy insurances after the house has burnt down.

Note that the VIX has actually fallen by more than 40% from year end highs.

 

Extreme positioning has been spotted in many assets. We have shown the below chart before and will show it again. Investors were max short VIX futures just before the sell off started.

This has now totally reversed, and the crowd is long volatility and the VIX. Not only is the pain trade up for equities, but a relative slow grinding market could be lethal to the new “hedged” investor. Bleeding theta is not the natural preference for most investors.

Source: charts by Bloomberg