In the Name of Greed, Fear, Liquidity and… Resilience?

I have focused most of my stock market comments on the US stock market.  Why?

Since the GFC of 2008 which originated in the USA;  money managers and investors had to do one choice. Allocate 100% of their equity exposure to the US stock market, in particular to the Nasdaq 100 index.

Red line is the ratio Nasdaq 100 / MSCI World (ex USA)  –    Green line is  US Total stock market (all US stocks) / MSCI World (ex USA).   NDX, Nasdaq Excess return is about 660% and US Total Market is 180%.

A long term view by BOFA:  Interesting to observe the underperformance from late 60’s to late 80’s (inflation and Bretton Wood)

NDX concentration is pretty amazing:  Top 5 companies are about 41% of the index

Similar portrait for the SPX. Top 5 = 21% (basically the same names)

Today the US market cap alone   is bigger than its next following 11 peers or about 59% of total world stock market.

The Top 6 companies in the world represent about 12-13% of total world market cap.

Since Ray Dalio said that Cash is Trash; CEOs have been quick in recycling such “garbage”.  NYSE active issues have increased about 17%. The  “efficient” regulators market approach has allowed the issuance of many potential promises under the anagram “SPACs” (special purpose acquisition company, also known as a “blank check company”).

Which resulted in the biggest ever equity annual inflows.

However, we can observe some strange anomalies!  Cumulative Advance-Decline volume for the S&P 500 index is up about 9% since the Feb 20 top while the index is up about 34%

Viewed differently:   ratio of SPX  Total versus Down Volume (Black line) and green line is SPX index. The story of concentration in a few names is amazing.  I have never witnessed in my career such distortion. Volume studies are very important to me and we have a “track record” decades long which has been broken.

The UP/DOWN volume ratio  is similar (Black blue line)  and SPX green line.

The two above charts show one thing. Stock pickers and fundamentalits have been simply “wiped out”. Not selecting and index based instrument as your allocation was a huge risk.  It also shows that cash volumes have not been the main driver behind price changes or…. “small” cash inflows/outflows are provoking bigger price actions. The market concentration can be viewed as a lack of market homogeneity since we have a wide indivual dispersion of returns.

This is best reflected in the VIX index and the Vix futures curve.

The dark red line is the constant 6months VIX future.  End of January 2018, the market was at the top, the Skew Index was at the bottom, Vix was around 10; setting the stage for Volmageddon.  The crowded trade at the time was selling volatility, being short VIX futures. A few ETN, ETP, ETF got wiped out in a few hours.  Market Makers concentration basically “cornered the Vix sellers. The Volatility supression regime was over in a bang.  Vix trading became popular around 2013 since contracts could be accessed through eletronic platforms. Volatility tends to spike and always come down so… selling Volatility became a “no brainer” trade. I would say this was really the first massive derivative crowded wave.  The Skew index (I call option expensiveness..) has been trending higher once again.

Since then, the use of VIX futures as a hedge has mostly been an “expensive” proposition.  Here is a bette view of the Vol. suppression regime (orange line is the 6month futures VIX)

We  have had a transition period from the Volatility suppression period to a new regime.  Speculative capital has embraced options (CALL buying – Golden line). Medias are full of stories about hordes of speculators targeting individual names and price manipulations. Equity PUT/CALL ratio (Golden line) has remained quite low this year while the expensiveness of options has increased (Skew orange line) and Index Hedging (green line below = Index PUT/CALL ratio) has increased.  This is an unusual situation but it has found sustainability because price action of the index has been sharply up (BTFD). Grosso modo, buying CALL option is fine if price keep moving up with speed.  I’ve said in previous posts that we have a derivative bubble so keep in mind that fast moving market is fundamental to make a profit. However… the higher expensiveness of options is becoming a probem. Apparently +70% of the options volume matures within 2-3 week. Why? Short dated option = less cash to commit. You win or you lose so ok to lose just a bit but if it becomes regular…. that’s the kind of outcome you tend to reduce.

Here is a better view of  the massive options volume

Options trading is basically a cash business since they need to be settled. You win or lose by betting on a short term outcome.  So we have:

• A situation where the majority of “players” are betting on price keeping moving up fast enough to make a profit (Call Buying).
• Massive options volume with a restricted quantity of  market makers and dealers who also need to hedge their exposure (Gamma, Delta etc).
• Hedgers bleeding because Index PUT/CALL index  has been a money losing strategy for quite a while.  In addition, many hedgers have been diminishing their hedging costs, implementing PUT spreads strategies ( cash level 100, buy a PUT @ 95 and sell one at 90). It’s ok if markets do not fall too much but it can be a deadly combination too.
• Index concentration in a few Mega Caps and …the US market as the capital attractor of the world due to its size.
• Cash market liquidity/volume distorted from reality and bad/narrow market liquidity.
• A over owned US market and relative high portoflio equity exposure
• Crushed short sellers meaning…no buying power on the way down
• Pensions funds pledging their riskier portfolios to borrow money to meet their obligations
• Excess leverage and a bond market with real negative yields.
• BTFD deep belief from the crowd that the FED and other central banks will always have your back

Ray Dalio said that cash is trash but I am pretty sure that He, and many others,  will start to feel uncomfortable when cash exit their pockets. Cash is optionality, it gives you the power to act when deemed most interesting.

My overall feeling is that Central banks and regulators are responsible for  inducing such situation. In the Name of Greed and Fear is Liquidity the sole symbol /factor of resilience?

It seems that headline inflation is real even if transitory.  We have thought several time in the past that Central Bankers had reached a crossroad. Have they now? As the popular saying says… “Don’t Fight the FED” !  The difference/potential change I see on the horizon is that we are moving towards a Monetary and Fiscal Policy Merger. COVID crisis has been the trigger since massive fiscal transfers were the sole real answer. Such merger is in my view on the radar screen and approaching faster.  The mighty Central Bankers will probably lose some power and they know it. The regulatory asphyxia of many small banks and the coming digital currencies are part of their strategy to remain relevant. Just keep in mind that markets do not like uncertainties.

My overall feeling is that the market structure and modus operandi is subject to change. ROC (rate of change) of  many indicators are way extended and for some,  already negative ( 3-6-12months basis). The speed of change is fundamental to sustain the current environment and modus operandi. Newspapers headlines are just emotional noise in the background.  Hard cash in the pockets could talk louder. A simple “mechanical” decision” to reduce risk /raise cash  from a relative low percentage of  asset managers is potentially an important trigger for higher volatility.