On June 12 of last year I suggested that the prevailing market dynamic was a function of a Wrong Playbook Bubble
whereby participants had failed to identify what was driving market price. The basic conclusion was that the so-called “smart money,” due to their fundamental bias that was focused on economic and earnings growth, failed to consider the technical nature of a market that was impossible to quantify in a model.
At the same time that the Fed was taking the discount out of the discount rate, we saw an explosion of financial analysts, investment bankers, and so-called alpha-generating hedge fund managers all using the same playbook based on valuation models. So while the Fed was making valuation irrelevant, more and more investors were relying on and utilizing the same valuation models to make capital allocation decisions.
With Ben Bernanke having turned all assets into commodities, market price is not driven by valuation and growth based on models and forecasts, it’s driven by positioning and sentiment based on speculation and fear.
If this market truly is just back-filling the gaps left behind by the financial crisis then making this area of support is very bullish and could point to new all time highs going into the fall.
was the critical 1265 pivot on the S&P 500
(INDEXSP:.INX) that goes back to 2008, and as you know, the market proceeded to rally 200 handles into the September highs squeezing every last bear in the process. Now, as the S&P sits at new post-crisis highs, those same smart money investors are bullish for the same reasons they were bearish at 1265 despite very little change in the economic and earnings landscape. You now hear them extol the virtues of equity valuation relative to bonds, predicting a massive asset allocation shift in what is deemed The Great Rotation. This is a classic case of confirmation bias and reminds me of the excuse to buy the breakout in 2007 because the world was “awash in liquidity” as the mountain of cash would have no choice but to buy stocks.
Before you go mortgage the house because of what someone on TV is saying, I urge you to turn off your computer screens, take a deep breath, and relax. This is what I did this past week, and instead of focusing on the tape, I decided to catch up on some necessary reading. I don’t know if it was serendipity or what, but I decided to check out the latest research piece by Christopher Cole of Artemis Capital Management
I cited Cole once in the past and find him to be a smart, independent market thinker who is saying what no one else is saying. He’s not one of these Twitter or media folks who regurgitates the same standard blabber that everyone already knows. Chris Cole is telling you something that Wall Street not only isn’t thinking about, but wouldn’t even be allowed to say. In his Q3 letter to investors, Cole gives a truly unique description of the current market dynamics that echoes some of the same sentiments posited in my Wrong Playbook Bubble article, but takes it to a whole new level.
This following is taken from Cole's Volatility of an Impossible Object
The problem is that the abstraction of the market has become an economic reality unto itself. You can no longer play by the old rules since those rules no longer apply. I know what you are thinking. You didn’t get your MBA to be an amateur philosopher – your job is to make cold-hard decisions about real money – not read Plato. You are out of luck. For the next decade this market is going to reward philosophers over students of business. Why? Because the modern investor must hold several contradictory ideas in his or her head at the same time and none of them really make any sense according to business school case studies. Welcome to the impossible market where…
Knowledge is not what you know but certainty in what you do not
Volatility is cheap and expensive at the same time
Fear is a better reason to buy than fundamentals
Risk-free assets are risky
Common sense says do not trust your common sense
Brilliant yet frightening.
The perfectly efficient market is by nature random. When the market has too much influence over the economic reality it was designed to mimic, the flow of information becomes increasingly less efficient with powerful consequences. Information becomes trapped in a self-reflexive cycle whereby the market is a mirror unto itself. Lack of randomness ironically leads to chaos. I believe this is what George Soros refers to as "reflexivity." The impossible object is a visual example of reflexivity.
Perception becomes reality.
We don’t know whether the US fiscal cliff will result in recession. We don't know what a collapse of the Euro would do to the global economy. We don't know whether China will experience a hard landing or whether Israel will start war with Iran… These are “known unknowns.” The probability of each shock event is already priced into markets meaning their occurrence may still undermine returns but not as much as if they came out of the blue. What are the “unknown unknowns”? Ask a psychic… I have no idea (that is the point) but if someone put a gun to my head and forced me to guess I would answer vol-of-vol itself. The more traders use ‘uncertainty’ as a market timing indicator the more unstable and cross-correlated markets will become. If you extend that concept to high frequency market microstructure and take it to the logical extreme you may see the problem. Today everyone is afraid of the next 2008 but I am afraid of the next 1987 (in equity or bonds).
What does he mean?
Knowledge is not what you know, but certainty in what you do not.
The 1987 crash was a negative gamma event and you will find elements of gamma or its cousin convexity found in many of history’s market disruptions. Gamma can be thought of as the volatility of volatility, and is one market exhibition of reflexivity, a term I have discussed many times in the past.
I think the best way to describe gamma is when you are long gamma, you get longer as the market rallies and get shorter as the market falls. When you are short gamma, you get shorter as the market rallies and longer as the market falls. You can see how negative gamma can raise your risk profile in a volatile market and exacerbate the volatility if it is systemic. The problem is, by the time the negative gamma kicks in, it’s often too late to do anything about it.
The prevalence of portfolio insurance caused the 1987 crash. As the market went lower portfolio insurance had you sell more stocks which pushed the market lower which had you sell even more. I think Cole is seeing risk of a similar event due to the way volatility is priced and traded today. In fact I believe the August crash of 2011 was a negative gamma event. I don’t think we knew how much negative gamma was embedded in robots trading ETFs until after the market melted. Risk-free assets are risky.
The market events on Friday, January 25, were a microcosm of the post crisis reflexive reality. While two egomaniacs were having a cat fight on CNBC about a meaningless company, the Fannie Mae current coupon 30-year MBS price was trading at par, yielding 2.50%. That is slightly more significant in a QE world where the Fed has pledged open-ended bond market purchases to keep a lid on interest rates only to see them rise in their face.
Fannie Mae MBS CC v 10YR UST
Friday’s price action in the bond market was a perfect example of how the reflexive nature of negative convexity can drive price action. As I stated in Explaining Irrational Behavior: It’s a Reflexive Process
As prepays slow and MBS extends so too does the need to hedge prepay risk thus turning MBS hedging Treasury buyers into sellers. The more rates rise, the more these low coupon MBS will extend and the more Treasuries they will sell. This is negative convexity in the other direction.
That seemed to be what was happening on Friday as the selling in USTs originated overnight due to the news out of Europe. Initially MBS held their ground but attempted relief rallies in USTs could not find any legs and MBS succumbed to the pressure as the current coupon took out the par handle. The reflexive relationship between USTs and MBS looked to be kicking in as selling begat more selling.
In my view this was a significant market development because of where the long end of the curve sits from a technical perspective. Recall in my 2008 Bond Market Prognostication:
I think 143-00 is a huge number. It was a climax top in 2008. It was made support in 2011 and 2012, and it’s very close to two standard deviations in the rising channel. If violated to the downside, a bond market top could be in place, but don’t expect it to go quietly; it will likely put up a tough fight.
US Bond Futures Contract Weekly
Fear is a better reason to buy than fundamentals.
This week we have a busy calendar
of market-moving events. Beginning with Wednesday’s Q4 GDP report and FOMC meeting. Then on Thursday we get Chicago PMI, and on Friday the January employment report followed by ISM manufacturing. If the market needs to test 143-00, next week could be a great opportunity. You can see on the chart there is enormous support in the area between 143-00 and the rising channel. The fate of the bull market will bet settled at these crossroads. Expect this area to get vibrated and the reflexivity of the MBS market to play a key role in how this gets reconciled.
Of course the stock market is playing a key role in how bond market price action is perceived. It’s not negative convexity pushing yields higher, it's investors selling bonds to buy stocks.
is not a time to dumb down the interplay between stocks and bonds in as simple terms of a Great Rotation. It’s not that simple.
S&P 500 Book Value
Stocks are cheap and expensive at the same time.
Investors buying stocks today are buying at one of the most expensive prices in a decade but also at one of cheapest valuations. You can see on the chart that despite the consensus that QE is pushing up stock prices, the multiple to book value (shareholder equity) is near the lowest of the cycle. If QE was responsible for rising stock prices you would think this would be reflected in a higher valuation, but clearly that has not been the case. In fact throughout the entire era of easy money designed to reflate asset prices the multiple paid for the assets has steadily declined.
The book value has simply risen along with nominal GDP and both currently are at historic highs. The price of the S&P 500 has risen simply on the back of a growing book value. For stocks to see a meaningful correction from here it will have to be in a contracting multiple. This can happen in times of rising inflation and/or rising interest rates. The 1982 low in the S&P coincided with a 1x price to book value ratio. You can see if the market experiences a bear market cycle that leads to multiple contraction, where that multiple settles could produce a wide variety of outcomes, with ranges from as little as a 10% correction to a 50% massacre .
Common sense says not to trust your common sense.
The biggest risk to higher stock prices is stocks going higher, and the biggest risk to rising bond yields is bond yields rising. The bull case in stocks isn’t predicated on earnings growth, it’s a function of relative valuation due to negative interest rates. If stocks want to rally to new highs and prick the bond bubble, that supposed relative value goes away. The bear case in bonds isn’t predicated on inflation, it’s based on the rally in risk. If bond yields rise it will be in the back of the curve, leading to a vicious bear steepening move that will likely put severe pressure on credit and equity risk premiums.
If you look at it on the surface and assume a few trillion parked in bonds could suddenly come roaring into stocks, you would obviously not want to miss that train. However the market is a bit more complicated than that. I believe Chris Cole is correct. I believe the power of reflexivity governs the market. As Cole says, the market is a mirror unto itself
. It is the impossible object.