We can all agree 2020 has been a year we will not soon forget – though most would like to. I can talk about COVID, vaccines, the election, geo-politics, or the fact I am really missing the Beer Bar at Grand Central, but instead, I will focus on markets. I want to highlight what I think are the most important current market dynamics: liquidity, positioning, momentum, and quant models, and then touch on thoughts for next year.
Having started my career as a market-maker in the Eurodollar Options pit in the mid-1990s and eventually running a trading desk at an investment bank, I have been obsessed with liquidity and what we often refer to as the market ‘pipes’. Under normal conditions, liquidity tends not to be an issue, as the world is full of liquidity providers. 2020, though, is in no way normal and we have seen some tremendous gaps in liquidity, especially in March. The important thing to note is that market making is now in just a few hands. The number of liquidity providers since the financial crisis has shrunk considerably. An article in early October, published by Bloomberg, showed that for NYSE listed stocks, two market makers (Citadel Securities and GTS) had greater than a 50% market share! So, what does this mean? It means that as much as people think there is plenty of market liquidity, if one of those two sources turn off their machines (even for a moment) or decide to widen out spreads or reduce lots available on the screens, it will have a major impact. My belief is that the existence of so few market makers is a systematic risk and the fact that this is getting so little press is shocking.
Second, let’s examine market positioning. Large short-term market moves are once again being driven by derivative positioning, good and bad. Looking back at this year, there have been a number of catalysts that have had an increasing impact on the markets, first being derivative positioning. Anyone reading my notes has seen me point out certain times when derivative market positions have greatly impacted market movements and direction. Post those events, I feel even more comfortable about those statements. What happened in March of this year was absolutely driven by fundamentals and the impact COVID would have on our economy, but the extent of the move was exacerbated by poor positioning. One major set of market players, taking outsized bets through their positioning, were risk parity managers. Anyone who knows me has heard me say this, but I will repeat anyway, “RISK PARITY HAS SIMILARITIES TO THE PORTFOLIO INSURANCE THAT CAUSED THE CRASH IN 1987.” Risk parity assumes that as markets go down, portfolio managers will be able to sell equity futures to reduce risk. What is that, if not portfolio insurance with a new name? Secondly, there were large pools of assets in the quant model driven volatility space. The most aggressive of those players are no longer in business. These investors were in large part the reason for the up 10%, down 10% markets we saw daily during March. Once those trades were unwound, with the helping hand of the US Treasury, we soundly found a bottom and the rally started. Bad derivative trades have caused market disruptions in the past and they continue to do so today. Investors will recall dramatic dislocations in 1987, 1997/98, 2008 (CDS is a derivative trade), 2018 and 2020. The cycle tends to be about every ten years, I guess that is how long it takes people to forget past mistakes.
It is important to note it is not just the moves down that have been exacerbated by derivate trades, some of the up moves have been propelled by derivative trades as well. The large tech call option buyer I pointed out in August? That investor helped intensify the upward move seen by certain Nasdaq stocks. The unwind of those call positions in September? That helped push the market lower. The unwind of their futures hedge of those call spreads? Again, this accelerated momentum launching the market to highs in mid-October. The VIX at 40 before the election, as people hedged portfolios and bought calls is what drove us this November. In an acknowledgement of the possibility of a push higher, there were massive volumes of call spreads bought in October. In this case, most were 3500-3600/3700 in SPX, funny we find ourselves just above 3600 as I write this. The point here is option trades are having a more significant impact on market moves. Even more so when you think about such few liquidity providers existing. Do you think Citadel doesn’t know about where bad option/derivative trades live and subsequently makes markets and provides (or doesn’t provide) liquidity accordingly? Something tells me the group from Chicago may hold their own interests above those of the broader market.
Next, momentum and computer driven trading. The move to passive investing and to momentum-based trading is striking to me. The theme has worked for quite a while and investors jumped into those strategies, as expected, chasing performance. Low volatility helped to continue this trend but, this year has generally not been great for quants. Their models have just not worked as 2020 produced albatross after albatross that no model could account for. The reason for this is, ‘how do you model 2020?’, you can’t. What investors need to be mindful of is the potential flaws in the models. Let me explain. I love the Black-Scholes option pricing model, not because it is absolutely the best option model, in fact many would argue it is not. I like it because it is flawed. Since it is flawed, I can understand how and when it doesn’t work and adjust at those times. In other words, the best model is sometimes a flawed model especially if you know how to compensate for those flaws. Though models can be an efficient way to implement an investment thesis, there is no replacement for a human at the wheel (with the scars of experience) in times of uncertainty.
Another interesting event occurred in the month of November. On a single day, the long momentum basket vs short momentum basket was down 23%. This was an unprecedented move (According to GS, the prior largest move was approximately 11%). So why did this happen? Simple. Positioning was at an extreme, one-way growth vs value or open economy vs stay at home economy. Secondly and more importantly, liquidity providers knew that positioning fact and adjusted their liquidity accordingly. Time and time again, liquidity is a major issue.
Finally, let’s talk about how I see the world next year. The number one lesson learned over my trading career is the common refrain, ‘you can’t fight the Fed’. The Fed wants inflation. They stated it. Janet Yellen is soon to be Secretary of the Treasury, and she wants inflation. So, what does that mean? We are getting inflation folks, period. My expectation is that in December, we will see people take profits, to avoid the impending higher capital gains taxes. The profit taking and tax avoidance will concentrate in the first half of the month. Around Christmas, we will see the start of a significant rally going into March. This will be driven by a massive stimulus bill that I believe will be passed. This bill will be fiscal and tend to help main street. The bill will likely look more like something we saw in the 60s vs what we have seen since the 1980s. So, you could say I am a bit bullish on equities, though I do think it will move to more global and value investments vs US and tech related opportunities. Again, higher inflation is the theme.
Higher inflation will be driven by a move to weaker dollar policy as we continue to print more money. This will be bad for bonds. At this time, I think bonds may be riskier than equities. That sounds strange but let me explain. I think the 40-year bond market rally is over. A fundamental transformation from monetary to fiscal stimulus will drive this move. The biggest negative to bonds is inflation. Good inflation is good for equities, bad inflation will cause serious issues in the bond market. I think the most bearish thing for equities is bad inflation and its impact on bonds. The most bearish thing for market liquidity is bonds. I truly believe everyone needs to rethink their allocation to bonds and credit going forward. Likely, this asset class will not provide the same protections and liquidity they have in the past. Again, Bonds are less liquid than equities, despite this, they have been placed into identical ETFs that are supposed to provide instant liquidity. This situation is tenable in normal circumstances but causes price dislocations in times of market tension. In March we had a taste of that illiquidity and stress. Bond ETFs were blamed. Who provides liquidity for bond ETFs? The same people who provide equity liquidity. I know, repeating myself on liquidity providers, but just another example of why that needs to be addressed.
Commodities have fallen since 2012. Capex investing in commodities has disintegrated during the last 8 years. Commodities come out of the ground and accessing them is much more like driving an eighteen-wheeler than a sports car. Eighteen-wheelers have great brakes (easy to slow down) but they require more time than expected to speed up. If capex spending is strong that tends to cause commodity prices to fall due to higher supply catching up with demand. If capex, or the ability to get stuff out of the ground, is low, then supply is low, and prices go up with demand. Currently, capex has been driven to minimal levels, supply is low in general, therefore prices should go higher if demand goes higher. I believe higher demand will be driven by US fiscal policy changes and this, in turn, will create higher commodity prices. I believe this will be the beginning of a cycle that lasts for many years.
In conclusion, many people like to compare where we are now to the end of the 90s. High tech stock valuations, low commodity prices and a market driven by the US and growth. I think that corollary may be misguided. Instead I offer that we are in a market like the 60s. A market driven by the nifty fifty stocks of the 50s; a time of fiscal monetary expansion. A time of great social unrest and a move to the “great society”. My hope is that the Fed can keep inflation under control. So that markets behave more like the first part of the 60s and not the last. My hope is that the US dollar stays the reserve currency of the world. This allows us to use the unprecedented government policies we have up to this point and not pay a steeper price. My fear is that they lose control of inflation and that the dollar is no longer the reserve currency of the world (see the move away from being pegged to gold by Nixon as the closest example). This would lead us into a stagflation environment similar to the later part of the decade and the 1970s, which even though I was under 10 in the 70s, I still remember.
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