V Is For 'V-Shaped'

I get questions from time to time both from readers and from at least two of my friends on the buyside asking what my “process” is for writing.

Obviously, I’m aware that I write a lot. And sure, sometimes when I step back at the end of the month and take stock of the total number of posts I’ve penned between my site, this platform and one other outlet where I’m a contributing editor, I think “gee, that’s a lot of posts.”

But none of it is really based on a “process” where that means having some kind of template and/or starting out on any given day with a list of posts I want to write and a schedule for writing them. That seems to be what people are looking for when they ask me about “process” and with apologies to anyone who has asked me that question and ends up reading this, that sounds like something akin to torture. If that’s what “process” is, well then you can count me out.

I mean I guess technically I do “work” for myself, but when I say (as I did in my Friday evening missive) that I’m a “slave” to the keyboard, you’ll note that the “slave” characterization was accompanied by the adjective “willing”, and as anyone who has followed me since I adopted the Heisenberg moniker in early 2016 is acutely aware, this has been an evolving transformation that has more to do with circumstance than it does to do with anything else. Mandatory lifestyle changes conspired with my geographical location to put me in a position where all there is to do is write and happily, what I like to write about is a subject that is constantly evolving (markets) and presents new narratives and new twists and turns on a daily basis. So basically, I just freestyle it as the mood strikes. That’s the “process” and I probably don’t deserve as much credit as I get from readers on this platform for being coherent. You’re getting polished Heisenberg here. Over on my site, you get off-the-cuff Heisenberg who is considerably less “procedural” about things.

Anyway, this post is a great example of how these pieces come together. Here it is, Saturday morning, and I was playing with the color scheme on one of my SPX charts to see how different shades of navy blue look on my 4K monitor versus my 1080p monitor while wondering (aloud, unfortunately) what percentage of readers use 4K monitors versus 1080p. Well that S&P chart was zoomed in on February so of course it’s V-shaped. As it happens, that chart window was overlapping a BofAML note pulled up as a .pdf and the title of the BofAML note is: “Post-shock hedges in case V-shaped recovery falters.”

So, I thought the following: “I’ll write something about V-shaped recoveries and I’ll use this anecdote about relying on happenstance rather than ‘process’ as an introduction.” And now here we are, 495 words in and talking about February’s V-shaped recovery. So let’s get to it without further ado. Here’s the chart:

(Heisenberg)

As you can see, the buy-the-dip mentality is not dead.

What accounts for that? Well obviously it’s not possible to answer that question definitively unless you just want to go with something amorphous like: “some people were buying.”

But it is possible to talk about some of the factors that are likely at play and also to think about it in the context of the post-crisis market regime.

For one thing, there’s buybacks. You might recall that two Fridays ago, Goldman noted that on Monday, February 5, the bank’s buyback desk saw the notional value of repurchases on behalf of corporate clients surge to the highest level since the market turmoil that accompanied the August 2015 yuan devaluation. Ultimately, the worst week for stocks in two years ended up being the biggest week on record for Goldman’s buyback desk:

(Goldman)

This week, the bank was out with an update on that and here’s what they had to say:

The Goldman Sachs Corporate Trading Desk recently completed the two most active weeks in its history and the desk’s executions have increased by almost 80% YTD vs. 2017.

They attribute this both to the correction and to the tax cuts. All told, Goldman expects a 23% jump in buybacks in 2018, which means that once again, the corporate bid will be the single largest source of U.S. equity demand.

Some people characterize buybacks as a synthetic short vol. position. I’m not sure I love that characterization, but what’s indisputable is that when you’re explicitly short vol., it helps that the largest source of demand for equities is to a great extent price insensitive (as the corporate bid is). More to the point, there is no question that buybacks have helped to underwrite the buy-the-dip mentality over the past several years. There is both an explicit element (they are actually buying shares) and an implicit element (the corporate bid makes other investors more confident in their own decision to stay long risk) to this dynamic.

In addition to that, the systematic deleveraging (or, more directly, the forced de-risking) catalyzed by the quick surge in volatility reversed itself. Although analysts who monitor flows from risk parity, vol.-targeting strats, CTAs, etc. are generally balanced in their assessment, there’s a rather unfortunate propensity for journalists and some bloggers to only talk about the downside. That is, they’ll be happy to warn you about the forced deleveraging, but then they aren’t so keen on telling you that once that’s run its course, there will be an inevitable releveraging unless conditions continue to deteriorate and this time, things have not in fact continued to deteriorate. As JPMorgan’s Marko Kolanovic wrote on Thursday, “in terms of systematic selling, this is largely over [and] in fact our models show that volatility targeting strategies may now start very slowly rebuilding their equity positions.”

Meanwhile, I’m not entirely sure that hedge funds were forced out of their positions. I’m just kind of winging it here (so as Jeremy Irons put it in Margin Call, “give me some rope“), but note what else Kolanovic says in the same note:

Let’s look at the positioning of investors and expected flows. First, we note that the Hedge Fund beta to equities experienced an unprecedented drop over the market sell-off. This de-risking (and in some cases shorting) happened largely via buying of downside options (and selling of index products) and might not be entirely captured by prime brokerage data. For instance, open interest on index put options rose by ~$500bn shortly after the sell-off. Hedge funds went from a near-record-high equity beta, to a near-record-low equity beta.

Now look at this chart from Goldman that shows you the most prevalent hedge fund positions as of the end of Q4:

(Goldman)

Finally, consider one more chart and the accompanying color from Goldman:

As the S&P 500 suffered its first 10% decline in two years, our Hedge Fund VIP basket declined in absolute terms but outperformed both the broad market and the largest short positions.

VIP

It kind of seems like no one was forced out of these positions and a lot of the stocks in that table are the names that have helped carry the market.

Again, that’s kind of piecemeal and isn’t meant to do anything other than perhaps spark some debate and make you think, but there’s enough in there to support the contention that this was a technical selloff and when it abated, the fundamental backdrop reasserted itself. You’re reminded that on the fundamentals front, Q4 earnings season has seen the highest percentage of bottom-line beats since 2010, with 80% of companies reporting. That’s pretty solid.

But operating in the background here is the same dynamic that’s been effectively running the show for at least three years. I’ve described this at length over on my site and rather than try and paraphrase myself, I’ll just excerpt one recent discussion:

Part and parcel of that dynamic is the idea that the central bank put has become self-sustaining – it runs on autopilot. Why wait on dovish forward guidance (or any other signal from the monetary gods) to buy the dip when you know with absolute certainty that in the unlikely event a drawdown proves to be some semblance of sustainable, policymakers will calm markets? If you know it’s coming, well then you should buy the dip now. This becomes a recursive exercise as everyone tries to frontrun everyone else and before you know it, dips and vol. spikes are mean reverting at a record pace as the prevailing dynamic optimizes around itself.

That right there is how “BTD” morphed from a disparaging meme about retail investors to an viable strategy. It’s a play on everyone else’s expectations about forward guidance. The ultimate irony of the last several years is that the only “alpha” opportunities are to be found in fleeting risk-off episodes at the index level. When benchmarks only go one direction (up) and when the pace of the acceleration is as frantic as it was in say, January, the quest for alpha is largely fruitless. The only “alpha” is buying whatever dip you manage to get from the headline risk surrounding Mueller, North Korea, an errant central banker comment, or [fill in the blank with your favorite tape bomb]. That mentality, once it becomes ingrained, feeds on itself and becomes more efficient over time.

The problem with this (well, besides the fact that stocks won’t always go up) is that thanks to modern market structure, it leads to imbalances or, more poignantly, it makes the market more fragile. We saw this on full display on February 5. The reason for that VIX spike and the subsequent systematic unwind was that thanks to the continual reengagement of the vol. sellers/dip-buyers, vol.-sensitive strats were running record equity exposure and the rebalance risk on those VIX ETPs was sitting at a record high. That scenario was a consequence of the dynamic described above. That’s the thing about self-feeding loops – they’re great on the way up, but they are harrowing when they reverse.

Have a look at this chart from BofAML:

shatteredrecords

(BofAML)

The footnote there explains the methodology, but suffice to say the concentration of what they deem “fragility events” is a direct consequence of everything said above about the intersection of dovish forward guidance from central banks, the dip-buying mentality that predictable forward guidance fosters, and the market structure evolutions that are effectively levered to that mentality.

Implicit in that chart is the fact that the we have already retraced much of the vol. spike. Here’s a brief excerpt from the BofAML note that chart is from:

With US equity volatility retracing at record speed and contagion across assets remaining so far contained, the S&P recorded its largest gain in 5yrs last week. However, concerns that a rapid V-shaped recovery and return to “pre-shock normal” may not be a given, investors are searching for cheap hedges to bolt-on to long positions to gain confidence.

Of course, “searching for cheap hedges” is hardly synonymous with panic.

So while we’re still not there yet in terms of recouping the entirety of the drawdown experienced earlier this month, investors’ propensity to buy the dip and thus to facilitate a V-shaped recovery is clearly still intact.

The issue going forward is that this propensity will almost invariably engender more and more fragility, presaging even more dramatic fragility events. Eventually, it stands to reason that one of these shocks is going to be traumatic enough to short-circuit the dynamic outlined above or, at the very least, to make it far less efficient.

In that scenario, the only thing that would restore the market’s faith would be explicit and forceful jawboning from the Fed, the ECB and the BoJ. In other words, they would need to actually move in and repair the mechanism that makes dip-buying a viable “strategy.”

But therein lies the problem. They desperately need to normalize policy because eventually, they’re going to need some room on rates and on the balance sheet to combat the next natural downturn. Freeing up some countercyclical breathing room (or, more colloquially, “replenishing the ammo”) may very well mean ignoring technical corrections attributable to market structure breakdowns no matter how acute they are.

Because if it comes down to a choice between letting the market experience harrowing bouts of volatility in the short term or stepping in by postponing rate hikes or slowing balance sheet rundown at the possible risk of leaving themselves hamstrung when the cycle turns (i.e. when they’ll really need some ammo), they’re probably going to leave you on your own at this point.

If only to ensure they can save you later.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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