This is an update to yesterday’s post about the inability of safe asset holdings to mitigate downside risk during equity drawdowns. As you know, I believe we are about to enter a potentially volatile period in the markets in September and October. So I am concentrating on where the risks lie. One of them is in market structure.
Yesterday, I wrote about the safest of fixed income assets not being able to serve their income or hedge functions and only providing liquidity. Today, I want to touch a bit on volatility. I do that with some hesitation as I am not a volatility trader and never have been. And, lots of non-experts are out there, making noise. But since what I am hearing about market structure there points to a second potential locus of downside risk from market structure, let’s touch on it.
This is not the 1990s, by the way
Yesterday, the Nasdaq was 30% above its 200 day moving average as it vaulted to another record close. Now, one might conclude from the price action that this is simply a reflection of economic optimism, juiced by investors chasing large cap stocks higher.
For example, yesterday I noted on Twitter that Apple was trading at 40 times earnings despite its gargantuan size (and relatively low earnings growth). That’s a huge multiple for a Titanic-sized company, usually reserved for more nimble and fast-growing smaller growth companies. And so, I thought of historic comparisons and came up with Microsoft, which traded over 70 times earnings at the end of the Internet bubble. CNBC’s David Faber retweeted part of my twitter thread, mentioning that GE, a large bellwether industrial company in the 1990s, traded up to 45 times earnings at the same time. So, that gives you a sense of how far this could go – much further up.
But, let’s remember that we are in the middle of a pandemic after an historic decline in output in the US and globally. This is not the late 1990s, when people were optimistic about growth at the latter end of a record-long expansion. Economically-speaking, we’re as close to the opposite of the late 90s as we could be. So I am thinking of momentum stocks as a long duration secular stagnation play more than anything else. The crowding into large cap growth is not a sign of economic optimism.
Shares up, Volatility Up
But, something curious has happened recently. While outrage Twitter was focussed on stupid issues like whether British singer Adele was engaged in ‘cultural appropriation’, shares were up wildly in the Nasdaq – and volatility up with them. This is a big deal. Normally, up moves are associated with volatility declining, whereas violent selling like the kind we had in March is when volatility spikes. What gives?
Rumours are flying all over the place. The first I caught wind of it was via Larry McDonald last week. On Friday, he wrote an article about some large institutional fund buying single-name call options on a bunch of large cap technology companies. On Monday, I retweeted him, highlighting the situation.
His take:
Over the past few weeks, there has been a massive buyer in the market of Technology upside calls and call spreads across a basket of names including ADBE, AMZN, FB, CRM, MSFT, GOOGL, and NFLX. Our friends at Citadel calculate, over $1 BILLION of premium spent and upwards of $20B in notional through strike – this is arguably some of the largest single stock-flow we’ve seen in years, they noted. We agree someone is playing with House Money, and they’re rolling large.
“The average daily options contracts traded in NDX stocks to rise from ~4mm/day average in April to ~5.5mm/day average in August (a 38% jump in volume). Given this group of 7 stocks accounts for a ~40% weighting in the NDX, the outsized volatility buying in the single names is having an impact at the Index level. So why are Vols moving yesterday/today when this call buying has been taking place for weeks? Yesterday CRM, one of the names we have seen outsized flow, rallied 26% on earnings – a less than ideal outcome for those short volatility from all the call buying. As the street got trapped being short vol, other names in the basket saw 3-4 standard deviation moves higher as well – yesterday FB rallied 8% (a 3 standard deviation move), NFLX rallied 11% (a 4 standard deviation move), and ADBE rallied 9% (a 3 standard deviation move). The most natural place to hedge being short single name Tech volatility is through buying NDX volatility. As such, there has been a flood of NDX volatility buyers with NDX vols up about 4 vol points in 2 trading days. And if NDX volatility is going up, SPX volatility/VIX will eventually go up too.” Citadel
The quote from Mohamed El-Erian I showed you yesterday got to this a bit. So, let me re-quote that passage one more time — with bold on the important bits this time:
Over the past few weeks, the fear of missing out on an unceasing equity rally has increasingly been expressed through call options — contracts that give the right to buy at a fixed point in future — rather than straight equity longs. That limits the amount at risk and gives users the ability to capture rallies. It has been supplemented by more downside “tail protection” aimed at safeguarding portfolios from sharp drops. With that, the Vix volatility index has decoupled from equity indices, adding to signals that a large market correction, should one materialise, would encourage more professional selling that could overwhelm the buy-the-dip retail investor.
What the hell is going on?
The attempted (super wonky) explanation
Kevin Muir at the Macro Tourist newsletter does the best job outlining what the hell is going on in my view. And rather than steal his commentary, I will link to the article in his paid newsletter here and give you my summation. I apologize because some of this is going to be super-wonky.
What’s happening is that the single-name large cap tech call buying has been so large that it has index-wide implications. And it has put the dealer community, which has to take the other side of these call positions and hedge them out, into a bind.
The link between an underlying stock or index price and its option price is not linear; it is curvilinear. That means as the price of the underlying stock or index moves, the ‘Delta’ – the percent change in the option price per discrete change in the underlying – moves. You don’t want that. So you hedge it out. And since they are effectively short the calls, having fulfilled their duty and supplied the institutional investor with flow, they have to buy tech stocks to keep their Delta hedged. They are effectively adding to upside momentum, creating massive multiple standard deviation moves in single names like Salesforce.com (CRM).
Doing this en masse and in size literally has a secondary impact. The change in Delta is called Gamma. And, the massive call buying, resulting increase in the options’ implied volatility and Delta hedging by dealers has made the dealers short Gamma. When implied volatility goes higher, the Gamma of both in-the-money and out-of-the-money calls and puts will be decreasing. And this too you don’t want.
To put an end to this explanation before I get hopelessly out of my depth, I’ll just say this whole nexus of events has caused volatility to spike, even as the underlying share prices have risen. It’s completely driven by heavy buying in the options market during a sleepy period in market action. It’s not a fundamental increase in volatility.
My View
The problem is what happens next. And that’s because the ‘artificial’ nature of the massive buying as shares vault higher due to events in the derivatives market, will be counterbalanced by selling that is just as massive when the buying stops.
What you have to realize is that any buying forced by massive call buying will turn to selling when the market goes down. That means the move down could be violent. And so, going back to what I was writing yesterday about the lack of mitigating upside in government bonds, a violent down move is going to be painful.
I will simply repeat what I wrote to end yesterday’s post then.
If my gut is right, the next drawdown will be large. And retail investors will hold on for dear life through at least 40% losses. But, at some point, for those in retirement or nearly there will be forced to cut their losses. And that will add to the selling pressure.
Is that what September and October portends? Let’s hope not. But this is the downside risk – a massive drawdown with nowhere to hide. Remember, the Nasdaq is 30% over its 200-day moving average. There’s a long way down before we find firm support levels.