On 22 May, we wrote:
“Although we have been more cautious in the last two weeks, Jay Powell’s interview in 60 Minutes, where he essentially doubled down on the Fed’s easy money policies, and potentially a second round of stimulus by the US Government, certainly has the makings of a FOMO-induced rally.
If such a rally coincides with rising yields, a tactical long in 10 Year Treasuries would be something we would recommend. Especially if credit conditions continue to tighten.”
Between 22 May and 10 June, the S&P 500 Index climbed from just under 2,970 to over 3,200. During the same time period, the US 10-year bond yield started at 68 basis points, hit 91 basis point on 5 June and retraced to 75 basis points by the end of trading on 10 June.
In one trading session on 11 June, the S&P 500 Index retraced most of the up move, dropping almost 6 per cent, while 10-year yields closed at 65 basis points.
In summary, long-term bonds and US equities both are green since 22 May albeit not by much. The golden age of 60/40 allocations and risk parity strategies continues.
On to the update.
Making Markets Move
From Bloomberg:
“Firms with high retail interest are up average 93% in a month”
Nobel Laureate Paul Krugman recently tweeted:
“Huh. The stock rally is being driven by small investors snapping up things like cruise lines. Doesn’t sound likely to end well.”
There is no shortage of those lamenting the irrationality of “Robinhood” traders or the market moving impact of the not-so-polite participants on the “Wall Street Bets” subreddit. It is somewhat ironic, that many of the very same commentators made light of these day traders for being long airline stocks at the time Warren Buffet declared that Berkshire Hathaway had exited all its positions across airline stocks in their entirety.
Markets are both cruel and humbling.
A 1,000% rise in a rent-a-car company after it has declared bankruptcy is difficult to rationalise for any long-term market participant. So is seeing an auto company that has never produced a vehicle become more valuable than Ford Motor Company literally overnight. Those steeped in either the Graham-Dodd deep value or Buffet’s quality-at-a-decent-price schools of investment appear the most affronted by such moves.
Our intention is not to throw shade on value investors or any other market participant or commentator for that matter. Rather, it is to revisit a topic that we keep coming back to over and over again — what makes markets move.
The truth is that trying to understand what market moves is nothing if not an open-ended pursuit. For markets are ever evolving and by extension what makes them move must evolve too. By definition then, one cannot fully understand what makes markets move. Rather, we all develop heuristics that guide our guide thinking and decision making in hopes of turning a profit for our efforts.
Way back in 2017, we wrote:
“Stock pickers follow all sorts of styles of investing. At their root, investment styles are heuristics for anticipating the flow of liquidity. Value investors position themselves based on price. Growth investors focus on the rate of change of revenues and earnings. Technical analysts search for repetitive behavioural patterns. And so forth.”
In a podcast, Jeremy Grantham of GMO articulated the same underlying concept far more comprehensively (quote from Tren Griffin’s tweets about Grantham’s interview with Partick O’Shaughnessy):
“There’s always been two major approaches to managing money: (1) deduce what the market thinks and look for unappreciated changes, good and bad and bet against the market. And bet your analysis has picked things up that the marketplace has missed. (2) use contrarian indicators like price to book, PE, price-to-cash flow, price to [find assets] that the market loved so much that it was constantly overpaying a little bit and underpaying for those nasty cyclicals.
Historical aversion to cheap stocks disappeared because they acquired the reputation for having won. The quants understood these were factors that worked. And indeed, academics wrote it up and got a lot of credit for it. And anyway, that was the past.
[The business now is] stock by stock analysis that’s not only labour intensive but risk intensive because you have to bet that things will change and you have to bet that the market is wrong. And that gives a lot of people, not surprisingly, a lot of trouble.”
The Tech Bubble
Last year, we wrote about the tech bubble and how it was not just a case of ‘irrational exuberance’ but also of contributing technical factors that led to the unprecendented rally (sorry for the long quote, but the explanation requires going into the weeds a bit):
“Up until 18 March 2005 the S&P 500 Index was a market capitalisation weighted index. That is, the weight of a stock in the index was equal to its market capitalisation divided by the sum of the market capitalisation of all stocks in the index. After 18 March 2005, the S&P 500 Index became a float adjusted capitalisation weighted index. That is, a stock’s weight in the index is equal to its free float market capitalisation – the stock price multiplied by the number of its shares freely available to trade, i.e., all shares excluding those held by insiders, locked-in as part of incentive programmes, held by the government or the promoters – divided by the sum of the free float market capitalisation of all stocks in the index.
The S&P 500 Index weighting calculation being agnostic to the free float and being based purely on a market capitalisation had an unintended consequence. That unintended consequence was the tech bubble.
All else being equal, a stock with fewer freely available shares to trade is less liquid, or illiquid, relative to a stock with more freely available shares to trade. Illiquid stocks tend to have more exaggerated price moves, up or down, than a liquid stock for the same value of buy or sell orders.
During the tech bubble, the market direction was just one way – up. So, the upward price moves in illiquid stocks, in general, were greater than those of liquid stocks. And with each passing day, as a result, illiquid stocks started comprising a greater and greater portion of the S&P 500 Index. As their weight in the index grew, the demand for these illiquid stocks grew from (i) passive strategies that allocate based on index weightings and (ii) active managers reducing their tracking error and benchmark risk. The growth in demand for these illiquid stocks was not met with a commensurate increase in the quantity of stock freely available to trade. Rather, the opposite occurred. Those that held the illiquid stocks became averse to trading them. Setting off a vicious spiral that required bubble-like prices for the market to clear. Of course, when the market was ready to clear, nobody wanted the illiquid stocks anymore.”
More recently, we added to our thinking about the contributing factors to the tech bubble and more general liquidity flows that impact markets:
“If you are wondering what happened in late 1990’s to enable the transformation, it was the repeal of the Glass-Steagall Act, which in turn removed the regulatory barriers stopping Eurodollars to make their way back into the US.
Given the scale of the Eurodollar system, its transformation from a facilitator of global trade to a source of domestic funding in the US had a profound impact in asset markets — essentially, it enabled the tech and housing bubbles.”
Asian Retail Investors
From the CFA Institute’s Research Foundation Briefs (emphasis added):
“When rates are low, as they have been recently, the “reverse convertible” is a popular structure: The client effectively invests in a zero-coupon bond and sells short a put option. The value of the put option and any interest due are combined and passed to the investor as a coupon. If the market falls below the option’s strike price at maturity, the loss is deducted from the proceeds of the zero and the net amount is the redemption value of the structured product. If the market rises above the strike price, the investor gets her money back along with a high coupon.
[…]
At the end of 2015, outstanding sales volume for retail structured products offered in major Asian markets (including China, Hong Kong, Japan, South Korea, and Singapore) exceeded USD750 billion, representing a compound annual growth rate of 4% since 2012.
For many years, a number of analysts and hedge fund managers have warned of the potential for large Asian retail allocations to structured notes, that offer fixed returns like a bond while selling options on equity indices, could exacerbate market moves during a sell-off.
These warnings were not wrong. During the fourth quarter of 2018, when markets fell precipitously, French bank Natixis suffered a US dollar 293 million loss linked to Asian structured notes.
The warnings, however, were not entirely correct either. Higher levels of volatility, which allow greater levels of yield to be extracted by selling derivatives, motivated further issuance of structured products. The higher yields on offer attracted flows back into these structured products. The flow of funds into these products dampened volatility — increasing selling of derivatives, which is simply selling volatility, reduces the ‘price’ of volatility. And this set off a reflexive process, lower volatiltilty led to higher markets, which attracted further capital into structured products, which pushed markets higher still.
Dampeners
The structure of indices, the flows into or out of the US and Asian retail flows in to structured products are some of the moving parts within the high optimized financial system that exists today.
Other examples include systematic strategies that buy (sell) equities on tightening (widening) credit spreads, systematic volatility selling strategies employed by the largest pools of capital in the world that harvest volatility risk premium and 60/40 allocation strategies that re-balance monthly between bonds and equities. There are countless other examples.
The point being that while retail, message board day traders may suffer debilitating losses at some time in the future, there are many dampeners in the market that are biased towards pushing stocks higher and enabling them to bounce back quickly from sell-offs. With these dampeners in play, the wherewithal of these day traders may far exceed what any commentator or value-savant may expect.
All of the above is a long winded way of us trying to say, the US equity market has room to run higher, a lot more room. Buy the dip.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.