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The Great Rotation? The Market Is a Bit More Complicated Than That


Now is not the time to dumb down the interplay between stocks and bonds.

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.

This area 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.
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