Be Careful What You Ask For
The S&P 500 is so close to all-time record highs - Santa arrived early!
And narratives are catching up with the market's advance:
» Core Inflation is lower than most thought it would be after hearing "higher for longer" all of 2023 - now at the Fed’s target rate of 2% by most measures.
» GDP growth is robust (highest in 6 quarters) - even if attributable to massive government spending.
» Market reaction, which Fed kinda-sorta confirmed last week, is that rate cut probability is near 90% for March and 100% for May - something I warned was likely in late November ;-).
In fact, all three of my very specific, high conviction macro market-timing calls occurred:
1. USD Peaks (early Nov)
2. 10Y into 4% (mid Nov)
2. FOMC cuts pulled forward (end Nov)
From that macro came many successful micro calls. The results are clear from both tactical trades in OPEN/CLOSED swing long positions for CLUB/EDGE clients, as well as the thematic watchlists I have maintained!
Case in point: these were my recommended stocks in that I created on my SECTOR ROTATION themes and track daily for clients in my live trading room - on a cumulative basis:
19 names presented on Nov 1st USD WEAKNESS +143%
12 names presented on Nov 16th HARD COMMODITIES +145%
14 names over last month plus on MID-CAP TECH +267%
15 names over last month plus on LARGE-CAP VALUE +160%
and just 10 names presented this month on SMALL CAP/CRAP +347%
2024 will bring new themes I'm sure, but one will likely continue and make all the difference for everything else:
My November 9th Client Post: "USD Has Likely Peaked".
"Falling yields are so bullish it's bearish!"
I normally relegate these more educational lessons/insights to my #macro-to-micro-support channel.
But given the shake-n-bake' of large intraday volatility we experienced Wednesday - that I warned about in advance Monday and again Wednesday morning...
And the fact we are but a few weeks away from what Craig and I have expected could be volatility-producing Jan OpEx...
Added to the new risk of downside convexity for the CTA crowd potentially selling more than $200bn of global stocks....I thought it a good time to remind clients how crashing lower yields can break dispersion trading, yield stacking and concentration bets.
Yes, that's right!
"Falling USD is so bullish it's bearish" warning is now turning into "Falling YIELDS are so bullish it's bearish" warning!
Yield Stacking, Dispersion Trading & Concentration Risk
I know many of us try to align our investment and trading approach to a focus on or mix of macro, technical, fundamental, etc.
But I think a simpler view of the world goes something like this for most:
Quant/Option-focused bulls assume VIX will continue to be suppressed - and they are right.
Macro/Fundamental bears await a data-print or govt policy/company-event trigger to disrupt those VIX-suppressing flows - and they too are right.
And therein lies the 'great' debate between Flows vs Macro.
But the institutional/systematic world isn't either/or.
They trade both, at the same time.
To really dig into what Dispersion Trading is and how firms trade it, here is a very academic review: Dispersion Trading Part 2
In layman's terms, here is also a very good podcast on ODTE and demystifying dispersion by Mandy Xu, Head of Derivatives at CBOE. She talks about the CBOE S&P 500 Dispersion Index (DSPX): A first-of-its-kind index designed to measure expected dispersion in the S&P 500 Index.
But I think the most popular FinTwit commentator on dispersion trading is Cem Karsen. I found a succinct summary (see below) of his last interview that warns of disruption to this seamlessly endless structural VIX-suppressing flow AFTER Jan OpEx.
The Big 2024 Unwind
Understanding dispersion trading will help to understand how Yield Stacking and Concentration Risk happens and how this potential unwind can be a big market mover in 2024.
To review (from an AI bot no less):
Dispersion refers to the spread or range of returns across different assets or asset classes.
Dispersion trading is based on the idea that the volatility of individual stocks is typically higher than the volatility of the overall index.
As a result, dispersion traders can potentially profit by selling options on the index while buying options on individual stocks.
However, this strategy also has the effect of supplying volatility to the market.
This is because when dispersion traders sell options on the index, they are essentially betting that the index will not experience large swings in price.
If the index does experience large swings in price, the dispersion traders will have to pay out to the buyers of the options contracts.
This can lead to increased volatility in the market as the dispersion traders are forced to buy and sell options in order to manage their risk.
The recent record dispersion in the markets is exacerbating this situation.
This is because it makes it more difficult for dispersion traders to find individual stocks that are sufficiently volatile to offset the risk of selling options on the index.
As a result, they are more likely to sell options on the index, even if they believe that the index is at risk of experiencing increased volatility.
By supplying volatility to the market, dispersion traders are making it more difficult for volatility to break out to the upside.
However, this also means that the dispersion trade is making the market more vulnerable to a sharp increase in volatility if the conditions that are currently suppressing volatility change.
@humbl8bee
>> In a nutshell, Dispersion Trading is the opposite of Market timing.
Market timing predicts when volatility will enter the market or individual stock.
Dispersion trading is bet against the market's predictions of volatility or after periods of high volatility, when the differences between implied and realized volatilities tend to be greater.
And that is why funds sell index volatility (usually trading at a premium) and buy "MAGNIFICENT 7" individual stocks (usually trading at a discount) - and how markets can and do 'crash up' while the majority of stocks underneath languish from lack of attention (because they aren't proxies for dispersion trading).
With that, it is no surprise that both Quant/Option-focused and Macro/Fundamental-focused traders have concentration bets in Mega Cap Tech Mag7 - AAPL, AMZN, GOOGL, META, MSFT, NVDA, TSLA. These have become the most-profitable and largest tech companies by market cap in the world in part because of dispersion trading (and share buybacks, but that's another post for another day).
I contend: Concentration bets in these V.I.P. stocks are the manifestation of risk-on AND risk-off.
With their heavy weighting in the main indices traded - QQQ (NQ) and SPY/SPX (ES) - big firms are able to maintain large hedges in SPX while taking on large bullish bets in Nasdaq 100.
And it is this 'pair trade', where the trade is offset to manufacture an overall VIX suppression affect, keeping realized volatility low in the spot/underlying issues and implied volatility higher in VIX products, that allows them to turn around and collect that juicy premium by selling VIX while bidding up markets!
So full-steam ahead as indices reach all-time-highs on macro narratives of Fed Pause, Yellen Yahtzee and economic growth, and strong corporate earnings amidst low unemployment and strong consumer spending?!
Oh, but if only it were that easy.
At the end of 2021, when the FED announced tapering in light of rising inflation, AS YIELDS ROSE, funds went short volatility on indexes and long volatility, as bond portfolio managers drove short volatility positions out and caused the dispersion trade to break down. This is in large part because of the effects of yield stacking.
Yield Stacking explained (with AI help @humbl8bee):
Yield stacking, also known as structured products, is an investment strategy that involves combining multiple fixed-income securities to achieve a higher overall yield.
These products typically rely on elevated interest rates to generate returns of 9-10%. However, yield stacking products also introduce volatility into the market.
This is because they often involve the use of derivatives, which are financial instruments that derive their value from an underlying asset.
Derivatives can magnify market movements, both up and down.
As a result, yield stacking products can be sensitive to changes in interest rates.
The higher returns generated by yield stacking products are largely dependent on elevated interest rates.
If rates fall, the returns on these products will also decline.
If interest rates fall, investors may liquidate their holdings in these products, leading to further market volatility.
If interest rates fall too far or too quickly, investors could even experience losses on their investments.
So this falls into the caveat of "Be Careful What You Ask For" category.
Federal Funds Rate market is pulling forward rate cuts in light of falling inflation.
Market is euphoric on that news, forcing a short-covering rally since November 1st of historic proportions.
But as we now enter a new year, with many bears converting to bulls, and bulls charging blindly ahead with inflows to both stocks and equities, it is time to revisit this important macro-to-micro concept that can trigger a large institutional money flow unwind that could easily upset the apple cart: Yield Stacking, Dispersion Trading & Concentration Risk
FINAL NOTE FOR 2023
This is my final Market Thoughts for the 2023 year.
I hope you have enjoyed and profited from both my written and spoken commentary, as well as contributions from my client-dedicated team.
My live trading room will be closed next week, but I will very likely pop in during the week and post in Slack.
Keep those notifications on!
I wish you all a very wonderful, regenerating holiday break.
And I greatly I look forward to working with you in the new year!