Positive Feedback Loops, Financial Instability, & The Blind Spot Of Policymakers

Authored by Francesco Filia of Fasanara Capital,

“Learn how to see. Realize that everything connects to everything else.” – Leonardo da Vinci

A Dangerous Market Structure is More Worrying than Expensive Asset Valuations and Record Debt Levels

Macro-prudential regulations follow financial crises, rarely do they precede one. Even when evidence is abundant of systemic risks building up, as is today, regulators and policymakers have a marked tendency to turn an institutional blind eye, hoping for imbalances to fizzle out on their own – at least beyond the duration of their mandates. It does not work differently in economics than it does for politics, where short-termism drives the agenda, oftentimes at the expenses of either the next government, the broader population or the next generation.

It does not work differently in the business world either, where corporate actions are selected based on the immediate gratification of shareholders, which means pleasing them at the next round of earnings, often at the expenses of long-term planning and at times exposing the company itself to disruption threats from up-and-comers.

Long-term vision does not pay; it barely shows up in the incentive schemes laid out for most professions. Economics is no exception. Orthodoxy and stillness preserve the status quo, and the advantages hard earned by the few who rose from the ranks of the establishment beforehand.

Yet, when it comes to Central Banking, and more in general policymaking, financial stability should top the priority list. It honorably shows up in the utility function, together with price stability and employment, but is not pursued nearly as actively as them. Central planning and interventionism is no anathema when it comes to target the decimals of unemployment or consumer prices, yet is residual when it comes to master systemic risks, relegated to the camp of ex-post macro-prudential regulation. This is all the more surprising as we know all too well how badly a deep unsettlement of financial markets can reverberate across the real economy, possibly leading into recessions, unemployment, un-anchoring of inflation expectations and durable disruption to consumer patterns. There is no shortage of reminders for that in the history books, looking at the fallout of dee dives in markets in 1929, 2000 and 2007, amongst others.

Intriguingly, the other way round is accepted and even theorized. Manipulating bond and stock prices, directly or indirectly, is mainstream policy theory today. From Ben Bernanke’s ‘portfolio balance channel theory’, to the relentless pursuit of the ‘wealth effect’ via financial repression under Janet Yellen and Haruhiko Kuroda, to Mario Draghi tackling the fragmentation of credit markets across the EU via direct asset purchases, the practice has become commonplace. To some, like us, the ‘wealth effect’ may be proving to be more of an ‘inequality effect’ than much, leading to populism and constantly threatening regime change, but that is beyond the scope of this note today.

What we want to focus on instead is the direct impact that monetary interventionism like Quantitative Easing (‘QE’) and Negative or Zero Interest Rate Policies (‘NIRP’ or ’ZIRP’) have on the structure of the market itself, how they help create a one-sided investment community, oftentimes long-only, fully invested when not levered up, relying on record-highs for bonds and stocks to perpetuate themselves endlessly - despite a striking disconnect from fundamentals, life-dependent on the lowest levels of volatility ever seen in history. The market structure morphed under the eyes of policymakers over the last few years, to become a pressure cooker at risk of blowing-up, with a small but steadily growing probability as times goes by and the bubble inflates. The positive feedback loops between monetary flooding and the private investment community are culpable for transforming an ever present market risk into a systemic risk, and for masking as peaceful what is instead an unstable equilibrium and market fragility.

Positive Feedback Loops create divergence from general equilibrium, and Systemic Risks

Positive feedback loops, in finance like in biology, chemistry, cybernetics, breed system instability, as they orchestrate a further divergence from equilibrium. An unstable equilibrium is defined as one where a small disturbance is sufficient to trigger a large adjustment.

QE and NIRP have two predominant effects on markets: (i) relentless up-trend in stocks and bonds (the ‘Trend Factor’), dominated by the buy-the-dip mentality, which encapsulates the ‘moral hazard’ of investors knowing Central Banks are prompt to come to their rescue (otherwise known as ‘Bernanke/Yellen/Kuroda/Draghi put’), and (ii) the relentless down-trend in volatility (the ‘Volatility Factor’).

Two Factors Explain All: Trend and Volatility

The most fashionable investment strategies these days are directly impacted by either one or both of these drivers. Such strategies make the bulk of the overall market, after leverage or turnover is taken into account: we will refer to them in the following as ‘passive’ or ‘quasi-passive’. The trend impacts the long-only community, crowning it as a sure winner, making the case for low- cost passive investing. The low volatility permeates everything else, making the case for full- investment and leverage.

The vast majority of investors these days are not independent from the QE environment they operate within: ETFs and index funds, Risk Parity funds and Target Volatility vehicles, Low Volatility / Short Volatility vehicles, trend-chasing algos, Machine Learning-inspired funds, behavioral Alternative Risk Premia funds. They are the poster children of the QE world. We estimate combined assets under management of in excess of $8trn across the spectrum. They form a broad category of ‘passive’ or ‘quasi-passive’ investors, as are being mechanically driven by two main factors: trend and volatility.

Source: Fasanara Presentations | Market Fragility - How to Position for Twin Bubbles Bust, 16^th October 2017. The slide is described in details in this video recording.

Extraordinary monetary policies have feedback loops with the asset management industry as a whole, reinforcing the effects on markets of such policies in a vicious – or virtuous - cycle. QE and NIRP help a large number of investment strategies to flourish, validating their success and  supporting their asset gathering in the process, and are in return helped in boosting bond and stock markets by their flows joining the already monumental public flows.

Private flows so reach singularity with public flows, and the whole market economy morphs into a one big common bet on ever-rising prices, in shallow volatility. Here is the story of how $15trn of money printing by major Central Banks in the last ten years, of which $3.7trn in 2017 alone, is joined by total assets of $8trn managed into buying the same safe and risk assets across, with leverage, indiscriminately.

How Market Risk became Systemic Risk

Let"s give a cursory look at the main players involved (a recent presentation we did is recorded here). As markets trend higher, no matter what happens (ever against the shocked disbeliefs of Brexit, Trump, an Italian failed referendum and nuclear threats in North Korea), investors understand the outperformance that comes from pricing risks out of their portfolios entirely and going long-only and fully-invested. Whoever under-weighs positions in an attempt to be prudent ends up underperforming its benchmarks and is then penalized with redemptions. Passive investors who are long-only and fully invested are the winners, as they are designed to be bold and insensitive to risks. As Central Banks policies reduce the level of interest rates to zero or whereabouts, fees become ever more relevant, making the case for passive investing most compelling. The rise of ETF and passive index funds is then inevitable.

According to JP Morgan, in the last 10 years, $2trn left active managers in equities and $2trn entered passive managers (pag.39 here). We may be excused for thinking they are the same $ 2trn of underlying investors progressively pricing risk provisions out of books, de facto, while chasing outperformance and lower fees.

To be sure, ETFs are a great financial innovation, helping reducing costs in an expensive industry and giving entry to markets previously un-accessible to most investors. Yet, what matters here is their impact on systemic risks, via positive feedback loops. In circular reference, beyond Central Banks flows, markets are helped rise by such classes of valuations-insensitive passive investors, which are then rewarded with further inflows, with which they can then buy more. The more expensive valuations get, the more they disconnect from fundamentals, the more divergence from equilibrium occurs, the larger fat-tail risks become.

In ever-rising markets, ‘buy-and-hold’ strategies may only possibly be outsmarted by ‘buy-the-dip’ strategies. Whatever the outcome of risk events, be ready to buy the dip quickly and blindly. As more investors design themselves up to do so, the dips are shallower over time, leading to an S&P500 that never lost 3% in 2017, an historical milestone. Machine learning is another beautiful market innovation, but what is there to learn from the time series of the last several years, if not that buy- the-dip works, irrespective of what caused the dip. Big Data is yet another great concept, shaping the future of us all. Yet, most data ever generated in humankind dates back three years only, in and by itself a striking limitation. The quality of the deduction cannot exceed the quality of the time series upon which the data science was applied. If the time series is untrustworthy, as is heavily influenced by monumental public flows ($300bn per months), what trust can we put on any model output originating from it? What pattern recognition can we really be hopeful of getting, in the first place? May some of it just be a commercial disguise for going long, selling volatility and leveraging up in various shapes or forms? What is hype and what is real? A short and compromised data series makes it hard, if not possible, to really know. Once public flows abate and price discovery is let free again, then and only then will we be in a position to know the difference.

Low volatility does what trending markets alone cannot. A state of low volatility presents the appearance of stuporous, innocuous, narcotized markets, thus enticing new swathes of unfitting investors in, mostly retail-type ‘weak hands’. Weak hands are investors who are brought to like investments by certain characteristics which are uncommon to the specific investment itself, such as featuring a low volatility. It is in this form that we see bond-like investors looking at the stock market for yield pick-up purposes, magnetized by levels of realized volatility similar to what fixed income used to provide with during the Great Moderation. It is in this form that Tech companies out of the US have started filling the coffers of not just Growth ETF, where they should rightfully reside, but also Momentum ETF, and even, incredibly, Low-Volatility ETF.

Low volatility is also a dominant input for Risk Parity funds and Target Volatility vehicles. The lower the volatility, the higher the leverage allowed in such players, mechanically. All of which are long-only players, joining public flows, again helping the market rise to record levels in the process,  in circular reference. Rewarded by new inflows, the buying spree gathers momentum, in a virtuous circle. Valuations are no real input in the process, volatility is what matters the most. Volatility is not risk, except for them it is.

It goes further than that. It is not only the level of volatility that count, but its direction too. As volatility implodes, relentlessly, into historical lows never seen before in history, a plethora of investment strategies is launched to capitalize on just that, directly: Short Volatility vehicles. They are the best performing strategy of the last decade, by and large. The problem here is that, due to construction, as volatility got to single-digit territory, relatively small spikes are now enough to trigger wipe-out events on several of these instruments. Our analysis shows that if equity volatility doubles up from current levels (while still being half of what it was as recently as in August 2015), certain Short Vol ETFs may stand to lose up to 75% or more. Moreover, short positions on long-vol ETFs can lose up to 250% of capital. For some, ‘termination events’ are built into contracts  for sudden losses of this magnitude, meaning that the notes would be prematurely withdrawn. It is one thing to expect a spike in volatility to cause losses, it is quite another to know that a minor move is all it takes to trigger a default event.

On such spikes in volatility, Morgan Stanley Quant Derivatives Strategy desk warns further that market makers may be forced to rebalance their exposure non-linearly on a spike in volatility. A drop in the S&P 500 of 5% in one day may trigger approximately $ 400mn of Vega notional of rebalancing (pag.48 here). We estimate that half a trillion dollars of additional selling on S&P stocks may occur following a correction of between 5% and 10%. That is a lot of selling, pre-set in markets, waiting to strike. Unless you expect the market to not have another 5% sell-off, ever again.

For more details, we describe the role of these different players in a recent video presentation and in our June Investment Outlook and May Investment Outlook.

It"s All One Big Position

What do ETFs, Risk Parity and Target Vol vehicles, Low Vol / Short Vol vehicles, trend-chasing algos, Machine Learning, behavioral Alternative Risk Premia, factor investing have in common? Except, of course, being the ‘winners take all’ of QE-driven markets. They all share one or more of the following risk factors: long-only, fully invested when not leveraged-up, short volatility, short correlation, short gamma. Thanks to QE and NIRP, the whole market is becoming one single big position.

The ‘Trend Factor’ and the ‘Volatility Factor’ are over-whelming, making it inevitable for a high- beta, long-bias, short-vol proxy to disseminate across. Almost inescapably so, given the time series the asset management industry has to deal with, and derive its signals from.

Several classes of investors may move to sell in lock-steps if and when markets turn. The boost to asset prices and the zero-volatility environment created the conditions for systemic risks in the form of an over-compensation to the downside. Record-low volatility breeds market fragility, it precedes system instability.

Flows Matter, Both Ways!

We will know soon if the fragility of markets is that bad. The undoing of loose monetary policies (NIRP, ZIRP) will create a liquidity withdrawal of over $1 trillion in 2018 alone (pag.61-62 here). The reaction of the passive and quasi-passive communities will determine the speed of the adjustment in the pricing for both safe and risk assets, and how quickly risk provisions will re- enter portfolios. Such liquidity withdrawal will represent the first real crash-test for markets in 10 years.

As public spending on Wall Street abates, the risk is evident of seeing the whole market turning with it. The shocks of Trump and Brexit did not manage to derail markets for long, as public flows were overwhelming. Flows is what mattered, above all elusive, over-fitting economic narratives justifying price action at the margin. Flows may matter again now as they fade.

Systemic Risk is Not Just About Banks: Look at Funds

The role of trending markets is known when it comes to systemic risks: a not sufficient but necessary condition. Most trends do not necessarily lead to systemic risks, but hardly systemic risks ever build up without a prolonged period of uptrend beforehand. Prolonged uptrends in any asset class hold the potential to instill the perception that such asset class will grow forever, irrespective of the fundamentals, and may thus lead to excessive risk taking, excess leverage, the formation of a bubble and, ultimately, systemic risks. The mind goes to the asset class of real estate, its undeterred uptrend into 2006/2007, its perception of perpetuity (”we have never had a decline in house prices on a nationwide basis’’ Ben Bernanke), the credit bubble built on banks hazardous activities on subprime mortgages as a result, and the systemic risks which emanated, with damages spanning well beyond the borders of real estate.

The role of volatility is also well-researched, especially low volatility. Hayman Minsky, in his “Financial Instability Hypothesis’’ in 1977, analyses the behavioral changes induced by a reduction of volatility, postulating that economic agents observing a low risk are induced to increase risk taking, which may in turn lead to a crisis: “stability is destabilizing”. In a recent study, Jon Danielsson, Director of the Systemic Risk Centre at the LSE, finds unambiguous support for the ‘low volatility channel’, insofar as prolonged periods of low volatility have a strong predictive power over the incidence of a banking crisis, owing to excess lending and excess leverage. The economic impact is the highest if the economy stays in the low volatility environment for five years: a 1% decrease in volatility below its trend translates in a 1.01% increase in the probability of a crisis. He also finds that, counter-intuitively, high volatility has little predictive power: very interesting, when the whole finance world at large is based on retrospective VAR metrics, and equivocates high volatility for high risk.

Both a persistent trend and prolonged low-volatility can lead banks to take excessive risks. But what about their impact on the asset management industry?

Thinking at the hard economic impact of the Great Depression (1929-1932) and the Great Recession (2007-2009), and the eminent role played by banks in both, it comes as little surprise that the banking sector captures all the attention. However, what remains to be looked into, and perhaps more worrying in today’s environment, is the role of prolonged periods of uptrend and low-vol on the asset management industry.

In 2014, the Financial Stability Board (FSB), an international body that makes recommendations to G20 nations on financial risks, published a consultation paper asking whether fund managers might need to be designated as “global systemically important financial institution” or G-SIFI, a step that would involve greater regulation and oversight. It did not result in much, as the industry lobbied in protest, emphasizing the difference between the levered balance sheet of a bank and the business of funds.

The reason for asking the question is evident: (i) sheer size, as the AM industry ballooned in the last few years, to now represent over [15trnXX] for just the top 5 US players!, (ii) funds have partially substituted banks in certain market-making activities, as banks dialed back their participation in response to tighter regulation and (iii) , funds can indeed do damage: think of LTCM in 1998, the fatal bailout of two Real Estate funds by Bear Stearns in 2007, the money market funds ‘breaking the buck’ in 2008 amongst others.

But it is not just sheer size that matters for asset managers. What may worry more is the positive feedback loops discussed above and the resulting concentration of bets in one single global pot, life-dependent on infinite momentum/trend and ever-falling volatility. Positive feedback loops are the link for the sheer size of the AM industry to become systemically relevant. Today more than ever, they morph market risks in systemic risks.

Volatility will not forever be low, the trend will not forever go: how bad a damage when it stops? As macro prudential policy is not the art of “whether or not it will happen” but of “what happens if”, it is hard not to see this as a blind spot for policymakers nowadays.

The addiction that could not be let go

In conclusion, we believe that markets are being brought into an unstable equilibrium, at risk of snapping violently. The stability of markets resembles the one of a pendulum held in vertical position: a small disturbance is able to create large swings. The swing can be so violent as to send tremors across the real economy, thus jeopardizing the hard earned progress on recovery in growth rates and unemployment of recent years. If positive feedback loops are ignored and bubbles are left unchecked, that may one day most unambiguously qualify as a policy mistake: the addiction to monetary steroids and price control that could not be let go, on time. A bust that was entirely predictable, if only macropru conditions had been a real target, and short termism had not prevailed.

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Full Fasanara Letter below...

 

Goldman Discovers Something Odd: Stock Moves Are Increasing Even As Index Moves Are Decreasing

One wouldn"t know it by looking at the moves in equity indexes, but this earnings season has been unusually volatile for stocks, which however has yet to translate into bigger moves at the macro level. That is the bizarre observation made by Goldman"s derivatives strategist John Marshall (whose team grew by one when ex-Deutsche Banker Rocky Fishman joined recently).

As Goldman shows in the chart below, while earnings day moves have increased in the US and globally, and stock dispersion generally has jumped to the highest since the Trump election, index moves have been the smallest in years. Goldman believes this is further evidence "of increased uncertainty in the equity market."

Quantifying the delta between the two vol indicators, Goldman writes that over the past two weeks, the SPX has moved an average of 0.17% per day (1-standard deviation BELOW its 3-year average), while looking under the hood at the stocks in the S&P 500 the standard deviation of returns has been 1.8% on average (1-standard deviations ABOVE its 3-year average). As an indication of just how much turblience there is below the surface, earnings day moves are 4.2x average daily moves for US stocks (3.6x for European and 2.3x for Asian) in this earnings season so far.

Using the charts below, Goldman shows the earnings day absolute move in stocks relative to the non-earnings days 1 month before and after. This includes data through November 9, 2017 for the current quarter. Earnings day moves are above average levels relative to the past decade, while non-earnings days have had lower volatility.

What does this bifurcated volatility pattern mean? According to Goldman, "this as evidence that fundamental uncertainty is rising (stock moves on earnings days) while general macro fears have fallen (stock moves on non-earnings days)." In practical terms, and based on the relationship of index volatility and the standard deviation of S&P 500 stock returns over the past 15 years, Marshall writes that he would expect "the SPX to be moving 90bps per day rather than the current 17bps. This implies realized volatility above 15%." Of course, that may not be possible (or allowed by central banks) because as we wrote two weeks ago, the beta of VIX spot has exploded to -19, which means that even a mere 90bps down day in the S&P could launch a self-reinforcing vol cascade which crushes the millions of vol sellers, unleashing a another sharp correction, or worse.

Goldman"s conclusion:

A rise in single stock volatility is generally associated with a decline in equity returns. Based on the relationship between the standard deviation of S&P 500 stock returns and forward returns in the SPX over the past 15 years  (controlling for index returns and index volatility), this elevated level of stock volatility would suggest a decline in the SPX of 0.8% over the next two weeks +/- 1.5%.

Alas, that observations is completely meaningless as due to the margin of error, the market can rise by 0.7% and Goldman can still claim it was right.

In any case, Goldman ends on a cautious note and warns that "while we do not believe this alone is a compelling reason to sell the market today (or buy VIX), we believe it is a trend worth monitoring closely."

7 Reasons Why Goldman's Clients Are Very Worried About An Imminent Crash

Over the years, the clients of Goldman Sachs have periodically found themselves on the verge of panic.

In March of 2015, we said that Goldman"s clients were most worried about the then-relentless crash in the EUR and how the resulting strong USD would hit US earnings (which, in retrospect, is ironic now that the tables have fully turned). Then In November 2015 we reported that "Goldman"s Clients Are Suddenly Very Worried About Collapsing Market Breadth" (and with good reason, the market was about to crash precisely for that reason). Several months later, Goldman"s clients were again confused - and worried - this time demanding that all their questions be answered before BTFD.

Then, in July 2016, Goldman"s clients again had a burning question: they were struggling to reconcile how extreme valuations of both equities and bonds can co-exist. As David Kostin explained one year ago, "client discussions reveal low portfolio risk coupled with concern that the rally lasts. Most investors have  been skeptical of the valuation expansion and have not participated in the 8% rebound from the post-Brexit low on June 27. Upside call buying has been a popular strategy to insure against upside risk." Additionally, Goldman clients were very worried that this remains a market without any earnings growth, and that much of the S&P upside has been due multiple expansion: "the S&P 500 forward P/E has already expanded by 70% during the past five years, exceeding all other expansion cycles except 1984-1987 (up 111%) and 1994-1999 (up 115%). Both prior extreme P/E multiple expansion cycles ended poorly for equity investors."

While it is unclear if said clients got over their concerns and got on with the BTFD program, what we do know is that since last July, already extreme valuations have only gotten more extreme, and as a result, Goldman clients are once again very worried, this time about an "imminent equity downturn" (banker euphemism for crash).

As Goldman"s chief equity strategist, David Kostin writes in his latest Weekly Kickstart, "the question every client asks: “Is an equity correction imminent?”

He then concedes that "Of course, at some point the S&P 500 will retreat"... but then gives two (painfully laughable) explanations why not just yet. First, however, he lays out the 7 reasons why Goldman"s clients are so fearful:

• 1. History. Many investors argue the bull market is “long in the tooth” and will soon come to an end. It has been 14 months since the S&P 500 index experienced a 5% sell-off and 19 months since the market had a correction of 10%. The last bear market defined as a fall in the index greater than 20% ended in 2009. The current bull market has lasted for 8.5 years and the S&P 500 has climbed by 260% compared with a 124% rise in earnings and a 64% P/E multiple expansion to 18x forward EPS.
   


• 2. Volatility (or lack thereof). Realized 3-month vol is nearly the lowest in 50 years. Implied vol as measured by the VIX stands at 12, a 6th percentile event since 1990. In his recent book, Tectonic Shifts in Financial Markets, the legendary Salomon Brothers economist Henry Kaufman (with the superb sobriquet “Dr. Doom”) references the lesson of Sherlock Holmes in “The curious incident of the dog in the night-time” that what doesn’t happen matters as much as what does. Low volatility across asset classes may be masking risks that are not evident today but will be obvious in retrospect.


• 3. Valuation. Equity valuations are stretched on almost every metric. The typical stock trades at the 98th percentile and the overall index at the 87th percentile relative to the past 40 years. Only on a Free Cash Flow (FCF) yield basis is the market valued at an average level (4.4%). But as we detailed in a recent report, the collapse in capex spending explains the FCF yield. On a cash flow from operations basis the market trades at the 87th percentile. Other asset classes are also highly valued vs. history: nominal Treasury yields (92nd), real yields (75th), and HY (75th) and IG (69th) spreads.
  


• 4. Economics. The current US economic expansion just celebrated its 8th birthday making it one of the longest stretches without a recession. Only the 10-year expansion during 1991-2000 and the 9-year expansion from 1961 to 1969 had longer durations. The median length of the 16 expansions since 1921 has been 42 months. Along with the question about an equity correction, another frequent inquiry is “when will the next recession occur?” Our economists assign an 18% probability of a recession within 12 months.


• 5. Fed policy. The FOMC has lifted the funds rate by 100 bp since it started tightening in December 2015. During prior hiking cycles, equity P/E multiples typically fell but multiples have actually expanded during the past two years. Futures imply one hike by year-end 2018 vs. our economists’ estimate of five. The uncertain pace of further tightening is a cause of much investor anxiety.
   


• 6. Interest rates. Two months ago, Treasury yields equaled 2.4%, ten-year implied inflation was 1.7%, and the S&P 500 stood at 2410. Our year-end forecasts of a 2.75% bond yield and a 2400 level in the S&P 500 looked rational. However, weaker-than-expected inflation data sparked a 35 bp drop in bond yields to 2.05% and a 2% stock market rally to 2465 (+10% YTD). Looking ahead, we maintain our year-end 2017 target (-3%).


• 7. Politics. President Trump’s fluid positions on domestic policy disputes in Washington, D.C. and geopolitical gamesmanship with Pyongyang and Beijing make political forecasting a precarious activity. One fund manager cited the “Law of Conservation of Volatility” under which there is a finite amount of uncertainty in the world. All the risk is now concentrated inside the Beltway and volatility outside of politics is close to zero. Of course, this could change at a moment’s notice.

As Kostin further adds, "investors cite the points above to justify their forecast of a looming correction. According to their narrative, high valuation leaves little room for error. A Fed tightening despite low inflation will spark concerns about the sustainability of economic expansion and lead to a jump in vol that may be compounded by a political event that in turn will spark a wave of selling. As factors reverse performance, quant funds will liquidate positions putting additional downward pressure on share prices and driving indices lower."

So what is Goldman"s response to these 7 very valid concerns? In a nutshell, "don"t worry and just BTD" or as Kostin puts it, "because investor euphoria is non-existent, an imminent start of a long decline seems
unlikely."

Skepticism abounds with normal 3% mutual fund cash positions. However, a sturdy consumer accounts for 69% of US GDP and buybacks remain persistent. Firms with high growth investment ratios have durable prospects even in the event of a market hurricane.

Sturdy consumer? Strong Buybacks? Has Kostin seen either of these two charts proving that neither of these statement is true, first the worst retail sales in nearly 4 years...

... or at least SocGen"s chart showing the biggest drop in buybacks since the financial crisis?

. 

Maybe Goldman clients should add an 8th concern: a grossly incompetent advisor. 

In any event, for those who enjoy having their hand held and buying stocks which trade at the 98th percentile in valuations, hoping for even higher prices, this is who Kostin "rationalizes" his grossly wrong assessment:

Although the preceding sequence of events could happen, we view it as a low probability event in the near-term for two key reasons:

First, investors are not complacent. In Sir John Templeton’s timeless observation, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Investors today are situated between skepticism and optimism. Few are euphoric as 27% of core managers are beating their benchmark. “Tormented bulls” best describes investor mentality. Alpha-seekers have normal cash positions (3.2% of mutual fund assets), active manager redemptions are offset by beta inflows (ETFs), and corporates continue to repurchase shares.

Second, US economic growth persists led by consumers that account for 69% of GDP. Monthly job growth has averaged 175K YTD, wages are rising (our leading indicator is a 2.7% rate), confidence is at the highest level since 2001, and household balance sheets are the strongest since 1980. For corporates, S&P 500 sales and EPS will rise by 5% and 7% in 2018. “Firms of tomorrow” with Growth Investment Ratios averaging 91% of CFO in past 3 years (vs. S&P 500 median of 17%) will grow 2018 sales and EPS by 7% and 12% and will outperform should a market hurricane occur (GSTHHGIR).

In short: yes, the market should crash, but because investors are not complacent (just don"t look at the VIX), and because the economy is so strong (just don"t look at the 10Y), everything will be fine.  Surely this optimistic bias would lead Goldman to at least expect some upside from here in the S&P? Well, no:

• "We expect the S&P 500 will end 2017 at 2400 (-2.6)%."

And scene.

Dear David: a) you are not even trying any more, and b) in your next weekly letter, can you please just let us know how much more Goldman"s prop desk has left to sell before it pulls the rug out of the market. Thanks.

"Visions Of Cataclysms": Why Eric Peters Is Starting A Long-Vol Fund

Is the recent streak of record low volatility about to end?

While countless analysts, pundits and traders have previously talked their book (if not staked their reputation) on claims VIX is set for an imminent mean-reverting spike, so far that has not happened and in fact net spec positioning in the VIX just hit a record short print as of the latest CFTC week.

And yet, on Friday night, in a notable change to the low-vol regime, Interactive Brokers announced it would hike volatility product margins ahead of what it warned could be a 100% surge in the VIX, a move which will be promptly copied by most if not all trading platforms. Will this then become a self-fulfilling prophecy - should maringed out traders decide it makes more sense to close out vol shorts than to add more cash - it is too early to know, however, in a separate confirmation that the current low-vol regime may be ending, last week JPM"s quant strategy team reported that "following robust performance in 1H ‘17, PnL of short vol premia stagnated over the past month... We see further risk for short vol from both rate increase as well as CB balance sheet renormalization."

YTD, short vol PnL (+5.1%) exceeds that of traditional beta (+4.2%) and value (+4.1%). Momentum YTD PnL of -5.2% arose from a broad-based decline across global equity indices (-5.1%), sovereign bonds (-2.1%), currencies (-1.4%) and commodities (-12.0%). Carry was flat (+0.9% YTD) as it was buffeted by positive bond carry (+3.9%) and negative equity index carry (-1.6%). Over the past month, short vol has stagnated at 0.26% and momentum has continued its decline by - 0.71%.

And with no further P&L to be made from selling vole, the question again emerges: is the vol-selling party coming to an end?

To answer that question today in abstract terms, we give the podium to our favorite Sunday morning commentator, One River Asset Management"s CIO Eric Peters, who today in lieu of his traditional weekend notes, has penned a piece titled: "The Case for Long Volatility" in which he explains that a surge in volatility is inevitable for one simple reason: human imaginations will soon run rampant with visions of cataclysms... something which that other derivatives guru, DB"s Aleksandar Kocic also said precisely two months ago, when he predicted that the "Market"s Current "Metastability" Will Lead To "Cataclysmic Events."

Some of the key excerpts from Peters" note:

To sell implied volatility at current levels, investors must imagine tomorrow will be virtually identical to today. They must imagine that bond yields won’t rise despite every major central bank looking to hike interest rates and exit QE. They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by decelerating global growth. And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure. I can imagine a few of those things happening, but neither sustainably nor simultaneously. It is much easier to imagine a tomorrow that looks different from today.

Zero interest rates and quantitative easing left yield-starved investors with few ways to achieve their target returns. Wall Street’s engineers developed many wonderful solutions to this problem. Their magnificence is matched only by the amount of negative convexity now lurking in investment portfolios.

As volatility declined, investors have had to sell even more of it to sustain sufficient profits. This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices. This in turn reduces volatility, reflexively. Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, I can imagine a historic reversal.

And at that point, investor imaginations will run rampant with visions of cataclysms. It is always thus, it is who we are. Confidence in a tomorrow that is indistinguishable from today will vanish, replaced by some new hysteria. It could be real or imagined. It could even be a bullish blow-off mania like 1999. Or maybe an endogenous crash, like 1987, when market moves were disconnected from the real economy. But the catalyst doesn’t really matter. What matters is recognizing that at this late stage, with implied volatility where it is, and asset valuations where they are, if you can imagine a tomorrow even modestly different from today, you must begin finding thoughtful ways to get long volatility.

Peters has imagined precisely that, and as a result, the CIO writes that he sees a "compelling opportunity developing in the months ahead" to go long volatility, and is launching a fund to capture it.

* * *

His full note below (link):

The Case For Long Volatility

I have an active imagination. A blessing and curse. I’m not alone. Of our many defining features, imagination is the greatest single thing separating us from other creatures. There is no higher power. Our ability to conceive of a tomorrow that is better than today is a precondition to discovery, invention. And these two things quite naturally stack, compound. Their summation has lifted us from the Stone Age to the space station. The journey has only just begun. This should be obvious to everyone but the most hopeless pessimist.

Along our upward trajectory are periodic interruptions. Some are natural, such as plagues. Others are economic, particularly depressions. But most are political, and the greatest arise when nations imagine future states of the world that are different and incompatible. These ideological conflicts can be devastating, lasting for years as hot or cold wars, but even so, they have barely restrained our rise. The motive force of humanity’s imagination, ambition, and drive to build better lives for our children is such that nothing has suppressed progress for long.

Economically speaking, our ascent is defined by rising productivity, the spoils of which determine prosperity. In modern times, we have imagined various ways to distribute this wealth; socialism, communism, free-market capitalism. I can imagine other approaches; the Chinese are exploring one. But even within existing constructs, there are nuances. Today in the West, capital owners collect a disproportionate share of profits relative to laborers. There is no intrinsic reason that this degree of inequality cannot persist. But in modern history it never has.

The private sector overwhelmingly sees itself as a more capable steward of research and development capital than governments. However, an examination of innovations traceable to state-funded initiatives during the past century suggests otherwise. I suspect the failure of Soviet communism led western free-market capitalists to imagine every element of our system to be superior. I imagine someday we will regard that black and white conclusion as foolish. China’s unprecedented economic rise and breathtaking technological advances should prompt Western self-reflection. So far it has not. I can imagine this being forced upon us.

In fact, I can imagine many things. I can imagine almost everything, except of course, things that never cross my mind. Those are unknown unknowns, Black Swans. In my lifetime, not a single such creature has reversed human progress, let alone markets. Not for long anyway. Lehman was not a Black Swan. I worked there for seven years and we spent most of them imagining the firm abruptly failing. Black Swans are generally magnificent, indistinguishable from magic - the internet, smartphones, cloud computing, quantum entanglement. The big risks are skewed to the upside, and manifest frequently. That is why we no longer live in caves. Yet periodically, our imaginations run wild with visions of cataclysms. I imagine that will never change.

In theory, investors compound savings at a rate commensurate with the upward slope of human progress. But people can pay anything they choose for assets and their derivatives. They periodically earn higher returns than that slope would indicate by bidding up prices far in advance of actual growth. However, they cannot do so forever without the gap between today’s reality and tomorrow’s promise becoming a chasm, prone to collapse. That said, almost any price can be justified if the slope of progress steepens, and every so often, something new appears that allows investors to imagine it will. But in modern history it never really has.

This leads me to investing. Which is principally about medium to long-term trend following. To obsess over much shorter time horizons is to imagine you can consistently outsmart people who imagine themselves smarter than you. A quick check on the number of billionaires who made their fortunes imagining such nonsense will tell you all you need to know on that topic. Anyhow, trend following is theoretically easy; over the long-term conditions improve. But because we base asset prices partly on their future value, and as every solvent investor imagines that trajectory to be upward, prices are almost always elevated relative to today’s reality - and thus prone to corrections. So trend following is easier said than done, and can be improved upon by periodic tactical adjustments, hedges.

With that in mind, it is hard to overstate the extraordinary nature of today’s landscape. All previous periods of extreme asset valuation required investors to imagine a vastly different tomorrow, a wildly optimistic future, a steeper slope. But today they expect the opposite. Due to unfavorable demographics and over-indebtedness, investors expect the slope to flatten, perhaps forever. Yet because of this flattening, they also imagine perpetually low interest rates, which they then use to justify extreme valuations across other asset classes in an endogenous loop that is increasingly disconnected from the real economy. This is the dominant pricing model for global assets today. I can imagine it continuing for a while still, but not in perpetuity.

Implied volatility is the price that connects two sets of people; those seeking to offload risks and those prepared to shoulder them. When imaginations are running wild, implied volatility is high, reflecting disagreement and uncertainty about what those risks are, and/or how they will resolve themselves. Low implied volatility reflects just the opposite. We are now at historic lows.

To sell implied volatility at current levels, investors must imagine tomorrow will be virtually identical to today. They must imagine that bond yields won’t rise despite every major central bank looking to hike interest rates and exit QE. They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by decelerating global growth. And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure. I can imagine a few of those things happening, but neither sustainably nor simultaneously. It is much easier to imagine a tomorrow that looks different from today.

Investment banks and asset managers devise creative strategies to make money once valuations exceed reasonable levels. These perpetual prosperity machines typically combine leverage and alchemy, transforming real risk into perceived safety. Examples abound. But in this cycle, a proliferation of cleverly disguised volatility-selling strategies has dominated. Zero interest rates and quantitative easing left yield-starved investors with few ways to achieve their target returns. Wall Street’s engineers developed many wonderful solutions to this problem. Their magnificence is matched only by the amount of negative convexity now lurking in investment portfolios.

As volatility declined, investors have had to sell even more of it to sustain sufficient profits. This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices. This in turn reduces volatility, reflexively. Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, I can imagine a historic reversal.

And at that point, investor imaginations will run rampant with visions of cataclysms. It is always thus, it is who we are. Confidence in a tomorrow that is indistinguishable from today will vanish, replaced by some new hysteria. It could be real or imagined. It could even be a bullish blow-off mania like 1999. Or maybe an endogenous crash, like 1987, when market moves were disconnected from the real economy. But the catalyst doesn’t really matter. What matters is recognizing that at this late stage, with implied volatility where it is, and asset valuations where they are, if you can imagine a tomorrow even modestly different from today, you must begin finding thoughtful ways to get long volatility.

And just like that, the "fat tails" funds are back.

Will Yesterday's Market Selloff Turn "Emotional": Here Are The Key Indicators RBC Is Looking At

Yesterday"s sharp S&P selloff, the largest of 2017, and the first time the market dropped by more than 1% in 110 trading days, may be just the beginning: that is the troubling thesis presented by JPM"s quant Marko Kolanovic, who as we quoted yesterday, warned that "following Friday"s option expiry, the gamma imbalance shifted towards puts for the first time in ~5 months and the market was ‘free’ to move again. Hence, it should not be a surprise that today, for the first time in ~5 months, we have a meaningful down move and intraday acceleration."

He concluded with another warning:"We maintain that the market is entering a vulnerable phase, where increased volatility can further contribute to equity outflows" and added that contrary to the narrative, yesterday"s selloff was "primarily technical and should not be fitted into a political narrative."

While there is no uniform agreement over the causes of yesterday"s selling, RBC"s Charlie McElliggott seems to agree with JPM that the selling which accelerated in the last half hour of trading is more "technical driven" than political/emotional, although as he explains it could potentially turn into an "emotional" selloff. Having warned about the "complete breakdown" in the quant model yesterday, a further deleveraging - i.e., selling - is dependent on whether the "mechanical" to "emotional" transition takes place today:

"...yesterday’s ‘vol-trigger’ induced mechanical risk deleveraging, which largely emanated from the accelerating breakdown in USD (and thus ‘reflation’) exposures...The final 30 minutes of the EU and US equity sessions will be a key-indicator in determining if there is ‘follow-through’ in the deleveraging. This is where ‘mechanical’ can transition to ‘emotional’ for fundamental players."

Here are his summary comments on the selling and what to look forward to:

• Yesterday was a mechanical deleveraging ‘VaR move’ as indicated by the Dollar’s breakdown as proxy for broad ‘reflation’ positioning.


• ‘Reflation’ trades had already seen waning momentum with the current fiscal policy implementation scare.


• To see a larger ‘deleveraging drawdown’ would require sustained higher volatility to ‘drag up’ realized vols in 20d / 60d models for short-term models—more than just a few days ‘blip’ in VIX.


• The final 30 minutes of the EU and US equity sessions will be a key-indicator in determining if there is ‘follow-through’ in the deleveraging.  This is where ‘mechanical’ can transition to ‘emotional’ for fundamental players.


• VaR encourages leveraging / deleveraging at ‘wrong times,’ i.e. ‘easy carry’ built-into system during a low-volatility regime.


• Shorting volatility is a multi-year alpha generating strategy utilized by the largest pension funds, asset allocators, asset managers and hedge funds alike that has profited from selling into short-term vol spikes (similar to ‘buying the dip’).  It will be continue being done until it ceases working; it remains a +++ performance driver for now.


• These ‘sharp’ drawdown events will continue to occur with greater frequency.  It’s a product of having more AUM than ever in systematic-trend / tactical-allocation / model-driven rebalancers nearly all with “vol targets” setting their leverage or allocation and thus, ‘momentum’ inherent at their root.


• Price-action and anecdotal client feedback shows nets taken down, grosses taken higher as shorts are pressed.

And from RBC"s detailed commentary:

Global cross-asset markets this morning show a ‘very modest’ follow-through (Spooz flattish, $/Y -40 pips, WTI -1.4%) on yesterday’s ‘vol-trigger’ induced mechanical risk deleveraging, which largely emanated from the accelerating breakdown in USD (and thus ‘reflation’) exposures. 

Thus far today though, the Dollar has stopped the bleeding, most notably against Euro, Mex Peso, Cad Dollar, Kor Won, Aus Dollar and Pound:

Rates / duration-shorts have been squeezed as expected, which is representative within equities of classic ‘risk-off’ / low-vol defensive behavior--“Anti-Beta” market neutral strategy saw its best one-day return since July 5th of last year, and 6th best day in the past two years.  Not surprisingly with the move lower in nominals and breakevens, we saw real yields move lower as well, with 5Y TIPS yields back to -16bps this morning from +4bps on March 14th.

Back to yesterday’s trade: Let’s be honest—it was just a -1.2% move in SPX.  But it was ‘ugly’ under the surface, with many of the below moves indicative of VaR ‘taps’:

• Dollar TWIs saw their second day in five of a ~2 standard deviation move lower (most notably against major squeezes in crowded shorts Euro, Pound and Yen);


• Credit saw High Yield and Bank Loan ETFs each see 2 standard deviation moves lower;

• Equity HF VIP Longs -1.6%;


• Copper -1.8%;


• WTI -1.8%;


• Equity ‘Value’ factor longs -1.8%;


• Basic Materials -2.0%;


• Equity ‘Beta Cyclicals’ -2.4%;


• Small Cap (R2K) -2.7%;


• ‘Early Cycle’ equities -2.8%;


• ‘High Beta’ equities -3.3%;


• US banks -4.8%;


• Beta biotech -4.9%

As I stated in yesterday’s note, the ‘long Dollar’ trade is the core of ‘reflation’-linked crowded macro trades.  To see it ‘crack’ was the key to the larger short-term model systematic VaR deleveraging which then rippled across said consensual ‘reflation’ positioning, which had already shown weakening momentum as actual fiscal policy implementation dynamics are ‘real-time’ sapping sentiment (see healthcare vote tomorrow and implications on tax-cuts). 

But to know if this move is something more meaningful than a one-day dynamic, I think you have to look to the final 30 minutes of the EU and US equities closes today.  It is entirely possible that the sessions behave “normally” per recent standards, grinding higher over the course of the day even.  But those final 30 minutes are so critical as indicators, because that is where we would be seeing the concentration of “mechanical” funds further deleveraging as a sign of “follow-through.”

But as far as the %age of money being run on models “short-term enough” where just one +10% day in VIX is going to completely shift the allocation is--finger in the air--not enough to perpetuate the unwind.  Recall yesterday I highlight 60d SPX historical vol having printed 10-year lows through March 20th at 6.4?  For relativity, after yesterday’s “vol spike,” that 60d realized vol is now just 7.1.  That"s why I keep stressing that higher vols need sustain for days to drag up 1m and 3m realizeds “high enough” to trigger ONGOING rebalancing / deleveraging. 

VaR as a risk-management tool is unfortunately ‘pro-cyclical,’ meaning that backwards-looking realized vol models inherently encourage ‘leveraging up’ / deleveraging at the perfectly wrong times (meaning it understates risk in ‘low vol’ regime and overstates risk in a ‘high vol’ environment).  And in the case of this current ‘vol-supressed’ regime, where asset allocators and pensions and assest managers and hedge funds alike are all encouraged by the alpha-generating returns of shorting vol into Central Bank asset purchases and NIRP / ZIRP, you can really ‘load the coiled spring’ with easy carry until something ‘tips over.’ 

Awkwardly, the industry-wide thirst for alpha (now more than ever in light of the performance dynamics of prior years, with now half of hedge funds back below their high-water marks—i.e. half the universe isn’t getting paid on performance again) has conditioned PM ‘muscle memory’ to further load the coil and sell vol / buy the dip.   Until we see a failure in either of those strategies, expect this ‘stat quo’ to continue.

The point that I have to keep reiterating here though is that in light of the today’s market structure and where the assets, these events will continue to occur with greater frequency.  It’s a product of having more AUM than ever in risk-parity / systematic-trend / tactical-allocation / model-driven rebalancers ALL with “vol targets” setting their leverage or allocation and thus, ‘momentum’ inherent at their root.  It’s unemotional and as always, doesn’t require a ‘headline’…sometimes it’s just a ‘butterfly flapping its wings.’

* * *

One final point with regards to the ‘surveying’ of funds on exposure moves into and off the back of yesterday, it was clear that the majority of yesterday’s portfolio movement was selling of longs.  Many shorts were actually pressed, so I would expect to see more of this today: GROSSES TAKEN UP and NETS TAKEN DOWN.

NETS DOWN, GROSSES UP AS LONGS SOLD, SHORTS PRESSED:

MOMENTUM LONGS (INFLATION, CYCLICALS) SEE THEIR SIXTH WORST DAY IN TWO YEARS:

MOMENTUM LONGS = INFLATION / CYCLICALS:

As Breakevens Plummet, The Narrative Has Reset

For those following the progression, and most recently - unwind - of the Trump reflation narrative, below are some critical observations from Charlie McElligott, head of cross-asset strategy at RBC.

Big Picture: Narrative Reset

On January 11th, I highlighted the risks developing via a potential breakdown of the USD--specifically as it related to its role as ‘chief proxy’ for the “reflation” trade.  Since that time, we have seen the Bloomberg Dollar TWI -2.4%, and with it, reversals in popular “reflation” trades despite BOTH flat benchmark S&P stock index and US 10Y yields over this period: ‘cyclical’ equities have lagged ‘defensive’ equities / ‘long duration’ significantly; ‘value’ has lagged ‘growth;’ ‘small cap’ has lagged ‘large cap;’ ‘momentum’ and ‘anti-beta’ factor market neutral strategies are significantly outperforming Q4 leaders ‘value’ and ‘size;’ popular ‘long copper’ significantly underperforming popular ‘short gold’;  crowded ‘EM shorts’ squeezing higher (from EEM to EMFX); popular short EUR +1.1% over this window et cetera. 

Again, the thought was that these crowded trades needed to see some of the froth come out…and that is exactly what has happened.  Today we see more of the same, with popular Q4 longs like ‘value,’ ‘high beta’ equities, HY, ‘small cap,’ ‘early cycle,’ ‘copper’ and ‘cyclicals’ all down sharply while popular Q4 shorts / ‘sources of funds’  like ‘long duration,’ ‘low vol’ stocks, ‘defensives’ and ‘growth’ all squeezed higher. 

A current snapshot of market behavior shows us that we are in the midst of a number of ‘other’ large symbolic pivots in the narrative / backdrop

"REFLATION’ BREAKDOWN CONFIRMED VIA ‘BREAKEVENS’: The much discussed ‘reflation unwind’ is now being confirmed by the last holdout of the trade—breakevens—which finally PLUMMETED lower today.  Feeding into this of course is crude, as ‘the’ proxy for inflation-expectations (and S&P energy sector -1.4% on session / -5.2% YTD, 2nd worst sector in the index). 

The downside of the USD firming-up (see next ‘bullet’ below) for risk-assets and the broad ‘reflation’ theme is the point made in recent “Big Picture” observations: crude sets ‘inflation expectations,’ which are a primary macro price-driver input for stocks, rates, credit and commodities (duh).  As the Dollar strengthens now, instead of being a representation of “reflation” as it was at the start of the year…USD now might be transitioning back to a more historical correlation where it is a drag on commodities instead.  This could again change where ‘higher Dollar / domestic reflation’ again “synch” if we were to receive ‘Trump policy clarity’ (taxes) or more robust ‘hard’ economic data that would in turn keep the ‘growth over financial tightening / inflation’ hope alive.

Ironically, to this ongoing point as crude as the most likely factor with regards to both left- and right- “tail” scenarios for stocks, we just received today’s API data after the close with gave us a shocking 14.27mm barrel build (vs a 2.5mm build expected)—which makes the 2nd largest weekly build in US history.  Gulp. 

DOLLAR PAUSES ITS OWN UNWIND, REACCELERATING HIGHER AGAIN: The USD remarkably is now UP 5 days in a row after that initial YTD sell-off which we spoke about up top, proving that its own positioning-excess has ‘come-off’(Mark Orsley today noting that total spec positioning in Dollar futures has been cut by 28% from the recent start of year highs).  This USD-move is largely driven by the move lower in said ‘breakevens,’ which along with ‘nominal yields’ grinding lower again too is helping send ‘real yields’ higher for the first time in weeks.  

Qualitatively too we see a combination of factors helping USD in recent days as well: 1) Fed walking market expectations for a March hike “back up” (Harker ‘pile on’ last night); 2) a growing-sense that a border-adjusted-tax system being included in the eventual Trump tax plan is again pivoting and need by repriced higher by the market (too much debate btwn House and Senate for B.A.T. to NOT be gaining-steam, especially following the ‘upbeat’ Rep. Kevin Brady comments this morning—per the consultants’ language on acceptance between the House and Ryan, B.A.T. probability should be closer to say 70 delta, but taking more time to get over the line with Senate); 3) ECB collective messaging on ‘comfort’ with EUR level and a dovish Draghi yesterday as well as generic EU geopolitical concern pick-up; and 4) very nascent signs of ‘soft’ data converting to ‘hard’ (specifically with regards to ‘labor’ market data, following last week’s NFP print).

NICE PERFORMANCE ENVIRONMENT WITHIN EQUITIES HF UNIVERSE: Ongoing strong YTD performance of the stuff that was essentially a ‘source of funds’ during “peak reflation trade” (‘growth,’ ‘anti-beta,’ ‘quality’ and ‘momentum’ factors all picking-up now after weak Q4’s).  This is indicative of an equities buyside which has increasingly ‘scaled back exposures’ to the ‘pure play reflation’ stuff and ‘thematic Trump policy trades’ which had become extraordinarily susceptible to a rogue tweet or headline.  Instead, exposure to ‘secular growers’ (tech, cons disc or healthcare) or idiosyncratic ‘event-driven’ names instead of ‘pure cyclicals’ is now the largest driver of equity HF performance from a bias-perspective, while overall factor dispersion and correlation breakdown provides an optimal return environment regardless of market direction (the ‘holy grail’ for M/N).  As such, we see that HFR Equity HF Index YTD is +1.4%; HFR Equity Market Neutral HF Index is +1.3%; and HFR Event-Driven HF’s +1.6% YTD.

One challenge going-forward though is the potential of a market breakout higher, where anecdotally I still don’t see a ton of risk-appetite per recent meetings / marketing and PB data on nets / gross.  “Rich valuations” with “Trump uncertainty” / “implementation delays of pro-growth policy” language is the baseline response from clients in US (and the dreaded ‘geopolitical / election risks’ in EU), which speaks to a ‘pain trade’ melt-up scenario being highly-likely as positioning data still shows that many are begrudgingly along for ride with only one foot in the water.

NOT-SO-MUCH FOR MACRO AND SYSTEMATIC HEDGE FUNDS THOUGH: The ‘reflation trend’ had been your friend in 4Q16 for macro funds, where there was a clear trade on post the Trump election, which added gasoline to the fire of “higher USD, short USTs / ED$, long small cap / high beta cyclicals, long crude, long copper, long CNH, long HY credit, short EM, short gold, short Euro, short Yen’ trading.  All the stars aligned, and collectively, Nov and Dec were the best back-to-back months in YEARS for macros. 
 
Then January of this year turned so hard that even scaled-down ‘long USD’ –related trades came off and took performance with it.  Now we chop on absolute index levels by-and-large, while the particulars under the surface (thematic rotation) drive the real returns…NOT DIRECTIONAL BETS / MOVES ACROSS ASSET-CLASSES.  Not for nuthin,’ but the same dynamic hurts CTA / trend-follower / systematic funds.  Not surprisingly, HFR Macro is -0.6% YTD, while HFR Systematic is -1.3% YTD and SG CTA Index is -0.5% YTD.  And we’re now seeing a number of high profile ‘brand name’ macro funds with January data that is worse than the above.
 
VOL BLEED EATING INTO ALPHA: Comments from two separate clients today on protection / directional vol bets dragging on performance:

“Seems like people getting crushed owning vol for a move.”
“Can’t have any premium on…realized vol just continues to bleed away.”

Despite the seeming rationale behind the generic refrain--“Is Donald Trump an 11 vol President?”—it seems that the potent-mix of +++ economic data making a case for 3 hikes (especially jobs, inflation and “soft data” per “animal spirits”) and /or a Fed looking at the risk of being ‘behind the curve’ in light of potential fiscal stim, along with the overall central bank shift away from flattening yield curves is allowing for dispersion of returns (on both the asset class as well as sub-asset class -level) to run like we haven’t previously experienced in the post-GFC era.  Interest rates are again being allowed to move per market forces--at least in the US—and as rates volatility suppression became the calling card of the QE era, interest rates as the ‘vol trigger’ mechanism within modern market structure / asset management is slowly being reset.
 
MISSION-CRITICAL FOR RISK-ASSETS GOING FORWARD: As stated, ‘soft’ data has to convert to ‘hard’ data in the coming months or else; not-just ‘reflation’ trades, but the backdrop for risky-assets in general, gets very mushy.  If the ‘hard’ data can’t see follow-through, the basis for much of what was touched-upon above gets tossed: the Fed would then again possible lower their dot plot as hiking expectations are reset; the rotation into cyclicals and “stuff that works in a higher rate environment” gets reset (exposing everything from financials to industrials to value to HY to bank loans), and we begin talking about the dreaded “stagflation” (remember to watch BE 2s10s curve inversion).
 
See below—first chart is the Bloomberg US Economic Surprise data category ‘breakout’ showing a snapshot of “soft data driving the beats” from Jan 30th.  The second is post- today’s data, which shows that the extent of the ‘soft’ data beats is declining, but against a move higher in ‘labor market’ beats (last week’s NFP).  The downside?  Retail and wholesale sector misses accelerated as an offset.  Stay tuned….

Carlson Capital: Border Adjustment Tax Would Lead To "Global Depression"

In their latest quarterly letter, Carlson Capital"s Black Diamond Thematic Fund (which was up 9.27% in Q4 and up net 19% in 2016) portfolio managers Richard Maraviglia and Matt Barkoff, who unlike Carl Icahn, Stanley Druckenmiller, Dan Loeb and most of the market, turned rather bearish weeks into the Trump victory, warn that “we may be looking at the grisly spectacle of stagflation”, echoing ongoing warnings from virtually all major banks that the market is wildly overpriced:

If the economy slows down against expectations it will have little effect on the upward direction of inflation. The rationale of inflation was cost-push and supply side constraints not demand side stimulus. Thus, we may be looking at the grisly spectacle of stagflation with the equity market on the highest cyclically adjusted valuations ever.

The two PMs are especially concerned about an imminent stagflationary episode, coupled with a concurrent recession, for the following reasons:

"Based on rising commodity prices and the more than one hundred percent year-on-year increase in crude oil, also an (OPEC) supply issue, we expect inflation to rise quite sharply perhaps as high as five percent over the next year. Anytime over the last thirty years that oil has risen one hundred percent year-on-year and long end interest rates are up one hundred percent year-on-year with a strong dollar, the US economy has slowed down often into recession. It squeezes consumer real purchasing power, slows real consumer spending at a time when export growth could slow given uncertainty over new, undecided policies and a less competitive currency. This is a global phenomenon; Japan has an extremely low unemployment rate too. The Eurozone and UK CPIs are destined to accelerate also."

Needless to say the fund is bearish, and here is the reason why in its own words:

Politics and history feature heavily in our thinking as we begin the year. We see a variety of factors that could cause macro deceleration just at the moment when investors have been dragged kicking and screaming into cyclical positioning, a place in which they are not truly comfortable. We further see much more dramatic risk from China. The combination offers attractive optionality to defensive positioning that is now under owned and attractively priced. As it relates to the Trump rally, we could argue that there were several drivers. The first was seasonality into year end. The second was the enforced bond-equity rotation which we suspect could be over in the short term. Third, fourth and fifth would be policy themes: corporate tax reform, infrastructure spending and broad deregulation. It was notable that in his first press conference there was no mention of any of these but rather unprompted criticism of the pharmaceutical industry.

Setting aside intra-market rotations, we note that hedge funds are really long the market right now. Recent CFTC data showed large US futures buying by hedge funds. Net futures positioning is now above the 80th percentile. Recent prime brokerage data showed net leverage +6.5 percent above the trailing twelve month average and is now close to a twelve month high.

In short, euphoria: "Sentiment is bullish; inflation is deemed to be a good thing despite the points we have made here. The Merrill Lynch Survey shows that we are in the euphoria stage:"

As it remains a constant topic du jour the hedge fund also touched on China, saying "monetary policy is tightening as interest rates in China have risen by almost one hundred basis points since the US election. Rising interest rates have caused a slowdown in corporate bond issuance. We would expect that Chinese New Year starting on January 27th will cause a further spike in rates.

Due to the pressure that rising interest rates will have on GDP given China’s leverage will reach three times GDP by 2018.

Thus, if China remains committed to a stable currency, it means tighter economic policy and downside to data now that government fixed-asset investment has begun to fall back to pre-February 2016 stimulus levels. The simplest way to observe this is through Shanghai house prices, which have just turned negative.

Carlson also has some thoughts on the current rate hiking cycle, which it views as further justifying the fund"s bearish posture:

Prior letters have been focused on the Fed and the implications of the rate hike cycle. These implications have not gone away, but have perhaps been forgotten and the path will be difficult to reverse. Regardless of current opinion, the truth is that tightening cycles almost always cause multiple contractions. The only exception was a six month period at the beginning of the chart below in 1987…

Next, some market observations: "we note that the market is rising on ever-decreasing breadth. In the second week of January when the averages made new highs, only 3.5 percent of securities closed at a fifty-two-week high. This was one of the smallest readings in decades. The average over one hundred years is almost fifty percent. The last two times breadth was this weak was in July 1999 and March 24, 2000."

Unlike Horseman, which suffered a big drop in the last two months of 2016, Carlson is boasting with a nearly 19% return for 2016 despite "a short beta position of 34.5%."

The fund remains short. We produced a return of 18.95 percent net of all fees in 2016 despite averaging a short beta position of 34.5 percent on average throughout the year by capturing important rotations based on our macro analysis. This amounted to a 3.34 Sharpe ratio for the fourth quarter and 1.64 for the year. We see more of these alpha transitions to come going forward but expect that we can also capture beta at some point in the first quarter of 2017. Volatility is here to stay and we also expect to be somewhat volatile and accept it as a cost of doing business and will attempt to control risk as much as possible while expressing our views.

Finally, and as the title suggests, the biggest risk according to Carlson"s PM is the US trade deficit, and specifically how the proposed Border Adjustment Mechanism would impact both the global economy and stocks:

We cannot overstate the impact of a declining US trade deficit and this is why we spent a large part of the letter discussing it. If the border adjustment mechanism is implemented as proposed we think it will cause a global depression and a major equity market decline. It is still unclear whether it will happen but at the very least we expect that US trade policy will put downward pressure on global growth. When this becomes apparent commodities will correct meaningfully and we will reinvest in inflation beneficiaries. Until then we are short cyclicality with what we assess to be tremendous risk-reward optionality through semiconductors, industrials and miners.

Full letter below:

JPM: "Turning Points In Market Trends Are Occurring At The Fastest Pace In History"

Ever get the feeling that the market has become frustratingly fast in responding to new information, with violent swings in either direction coming ever faster even if ultimately the "BTFD" mentality always seems to prevail? Well, it"s a fact. 

As JPM reports in a new analysis, citing quantitative and qualitative metrics, markets have become more macro driven and react faster to the new information. A qualitative example below shows the reaction time for recent major events (August ’15 selloff, Brexit, US Election, Italy Referendum) that has compressed from weeks to hours (Figure below).

In empirial terms, this means that quantitatively, we are noticing a higher density of market turning points. The next figure shows the average variability of asset trends (averaged across major asset classes) that show turning points occurring at the fastest pace in recent history (~30 years).

Given the engagement of central banks with markets and geopolitical developments, it should not be a surprise that markets are more macro driven. Furthermore, thanks to the ubiqutous presence of collocated HFTs, which respond to to headlines in microseconds, not to mention that information is created and consumed at a much faster pace than e.g. a decade ago (think of twitter, smartphones, etc.), the market is generally much "faster."

As JPM"s Marko Kolanovic also points out, "an emerging class of fully automated quant strategies is also likely speeding up the market reaction – these strategies process and trade on new information (e.g. feeds from tweets, press releases, etc.) in real time. Finally, we now live in a world in which everyone is a momentum chasers. As a result, the increased popularity of trend following strategies is also likely to contribute to shorter and faster trends, as strategies react quicker and lead to potential over/undershooting of fundamentally justified levels."

What are the implications of this fast-moving market? Some further thoughts from JPM:

Macro investors cannot ignore these developments, as they will need to react faster, compete with machines, and will be left with more risk in the form of market turning points. CTAs provide a good illustration of the direct of impact of quant strategies on asset flows. Figure 7 shows estimated equity flows, and Figure 8 estimated bond flows (the red line is actual exposure of a broad CTA index to the asset class, i.e. fund beta, and blue line is our model based out-of-sample forecast of the same position – note close correlation between the two). In 2015 and early 2016 these investors took substantial positions in equities, and the recent shift from a record long to short bond position contributed to a widening of bond yields.

Fundamental stock investors cannot ignore quant strategies either. Stocks are increasingly driven by (market neutral) factor exposures at the expense of fundamental drivers. Figure 9 illustrates this for one particular low volatility stock (JNJ, correlation to sector vs. correlation to low vol factor). Ten years ago, JNJ stock returns were entirely driven by sector fundamentals, but currently half of the stock’s returns are driven by factor returns (low vol factor). We also notice an outsized impact of stock returns around quant rebalances that typically occur at the end of the month (and first week of the month). Figure 10 shows that probability of a large move for stocks in a momentum portfolio are up to 3 times as large during turn of the month rebalances, as compared to other days in a month.

That said, fast moving markets are becoming a problem for everyone, not just macro investors. Stocks are reacting quickly to news, which leaves human investors less time to act. An example is earnings announcements where stocks immediately adjust to a price level and there is very little post-earnings drift. Figure 11 shows the size of earnings moves (normalized to ~3%) that are realized as gap moves (as opposed to post earnings drift) over time. Note that over the past decade, earnings drift has largely disappeared as stock prices adjust instantaneously. Similarly, market correlation started exhibiting strong seasonality – they are high outside of earnings season, and quickly break down at the time of announcement. This seasonality is further exacerbated by the increase of passive assets that drive correlation higher (outside of earnings season).

Furthermore, the ongoing mega-shift of funds from active to passive strategies continues to distort the "efficient market."

According to JPM, the level of passive indexation reached all-time highs with estimated ~35% of equities invested in capitalization weighted indices (up from ~15% 10 years ago). If indexed assets are relatively small, passive investing is a great cost-effective strategy. Passive investors are effectively piggy-backing on the most efficient, optimal, market portfolio. However, if the asset base becomes too large, passive investing may prevent market efficiency and lead to a misallocation of capital (large companies get larger, and small ones do not have capital, regardless of fundamentals). A large increase in passive assets can also cause distortion of valuations (e.g. favoring momentum vs. value, large vs. small, etc.). Investors are increasingly asking whether the current level of passive assets is already a problem for markets, and even the economy as a whole.

Figure 13 shows the recent trend in passive vs. active flows, and Figure 14 shows the increase in passive equity assets (as a % of total equity assets) as well as the number of companies listed in the US (on an inverse scale). There is a significant negative correlation between the number of new listings and size of passive assets. Although the correlation between the two is highly significant, this does not necessarily mean that passive assets caused this decline of new listings. The trend of capitalization weighted indexation may peak and start reverting over the next few years, especially if factor and stock dispersion cause broad capitalization weighted indices to underperform.

What is the preliminary conclusion? Well, for human investors competing with algos, robots and "Artificial Intelligence", will become even more difficult, not least of all because so much capital has shifted and continues to flow from active to passive strategies. As a result, ordinary, carbon-based investors will find they are increasingly at a disadvantage, even as the market drift from "fair value" continues to grow, making a major market "repricing" event increasingly more likely, while assuring that the losses for active market participants, mostly of the electonic variety will be dire.

Unfortunately, with few regulators able to grasp the major shift below the market"s surface, and especially now that deregulation is about to sweep Wall Street, there is little hope any of these concerns will be addressed until it is too late. In the meantime, prepare for markets that keep getting even faster, even more micro-volatility, even if the BTFD impulse continues to prevail until one day, the disconnect is just to great and the long overdue "mean reversion" event finally kicks in.