Remember the story of the big bad wolf and the three little pigs? If not, it goes like this: two pigs quickly build houses of straw and mud and then play and frolic for months, while a third pig, the careful one who didn’t play, slowly and humbly builds a house of brick to protect him from that roving wolf. The other pigs make fun of him, of course. But in the end, only the prudent pig is safe from the mean ol’ wolf.
In Kindergarten, at Stevensville Elementary School, I had to play the part of the pig with the straw house. Clifford Munson got the lead role—the pig with the brick house. When the big bad wolf came, Clifford got all the applause while I sulked like….well, like a six-year-old.
It’s funny how childhood memories stick with us. I can’t even remember the names of some dates I had in college, but I still remember Clifford Munson getting to play that heroic, lead-role piggy.
But despite my wounded pride, the moral of that story still hangs on me so many schools and years later. In short: don’t be a silly piggy. And there’s something about those three little pigs that resonates in today’s markets—especially when it comes to the options trade.
Last year I sat before a panel of successful CTA managers at the oh-so-fancy Harvard Club in Boston. The majority of them were gloating on the immense returns they were making “selling volatility”—a premium gathering strategy of selling puts (largely in the equity trade) in a world without any fear of a big, bad market wolf.
To them, the trade came down to this, selling and collecting options premiums (their market equivalent to flood insurance policies on desert properties) was (and perhaps remains) a no-brainer. That is, no risk, just reward.
One of the more quiet managers in this group, an applied math genius who moonlights as a classical musician, was a little less brash than his panel mates. To him, that desert without floods or market without big, bad wolfs was the real fairytale.
In other words, he was thinking about brick houses—or buying vol, one tiny, careful and patient brick at a time.
But how could the other little CTA piggies be so light-hearted and optimistic, so carefree?
In their minds, the markets have no visible risk. And so their option (gamma) hedging and risk premia products surged ahead. “Sell vol! Sell away! It’s mana from Heaven!” The VIX—or so-called “fear-index”– then as now, was at floorboard lows and the sun was shining on free market euphoria and premium gathering.
I’ll agree with the euphoria, but not on the free markets. It should come as little surprise to those familiar with my views on what the central banks have done to price discovery (and that once sacred concept of natural supply and demand) that nothing to me is natural or free about post-08 markets and post-08 investing. Central Banks & Market Distortion.
For you bulls, I understand and empathize with the eye-rolling. We “bash-the-Fed” types have been crying wolf since at least 2013. Admittedly, I never thought central banks would ever be this “supportive”—i.e. crazy. I never thought they’d be this addicted to stimulus. I never imagined they’d collectively create $20T of currencies from thin air without considering the consequences.
Still, the bubbles these banks (and Wall Street salesmen posing as TV “economists”) have created are real, and all bubbles pop.
Just pull out your iPhone and take a look at the 10-Year daily chart of the S&P 500. You’ll see a BIG, Everest-like bump up and to the right. Now if you were to overlay that graph with a timeline of QE and ZIRP (Fed money printing and low rate policies), you’d see an obvious correlation between artificial stimulus and artificial highs. QE and the S&P.
But regardless of whether they be natural or artificial, market highs are fun, and for the little piggies in the mud-housed options trade, even more fun. Fed support makes the big, bad market wolf seem like an obsolete thing of the past. There’s nothing to fear anymore, the Fed will save us. “Want some cheap puts? We’ll happily take your money. Cha-ching.”
It’s just possible, however, that the idea the Fed will save you is the new market illusion, as every market bubble is backed by illusion. In 2000, the dot.com bubble lived off the illusion that the Internet had changed everything and that tech stocks could only go up. In 2008, the sub-prime bubble lived off the illusion that housing prices could never go down.
Today, in the “everything bubble,” the current illusion is that the central banks and their PhD’s have your back, that more debt solves old debt and markets have a great big (albeit academic, experimental and expensive) airbag to protect you from floods, wolves and, of course, natural volatility.
For years now (and perhaps even for years to come) there’s no doubt that central bank support has been a real investment tailwind. After all, if your credit card has no spending limits, and better yet: no payment requirements—life is pretty fun.
Our central banks have no spending limits, but there will be a price to pay.
For now, however, we investors (who have confused $4T/year of credit expansion in China and temporary boosts from post-2014 commodity deflation as a global growth “breakout’) and those central banks just keep ignoring that part—you know, the bill to pay: the reckoning. For over 100 months, the Fed has essentially taken the fear of the big bad wolf—and thus volatility–out of the markets.
We’ve seen over 50 market dips since 2008, and if you bought every dip, you made money—every time. Does that seem like a normal market? Even this week, as the wagons circle around Trump and his headline-making (and Tweet feverish) Comey/Russia debacle, the market tanked for a day and then shot back up. As for the VIX, it panicked for about a split-second and then fell back to yawing levels.
In other words: there’s nothing to fear (or so they say) and thus the volatility selling of the mud and straw hut piggies rages forward.
Today, over 20% of risk premia strategies are spread across asset classes and dedicated to selling volatility. Such hedging plays (and premium gathering) have a great (and addictive) way of temporarily managing market volatility, and thus market anxiety. Hence the VIX just keeps smiling and markets basically keep rising.
The Fed. It affects everything.
Selling volatility has a direct correlation to bond yields, and thus: the Fed. That is, as bond yields decline, premium selling (and thus volatility dampening/hedging) increases. Needless to say, with central banks in general, and the Fed in particular, buying trillions of dollars’ worth of bonds, those yields kept falling (to even negative rates across the pond) and thus the premium selling (i.e. straw and mud house construction) kept rising.
Stated otherwise: after almost a decade of artificially reducing yields and tail risks, the central banks have created a historical regime of profound and artificial volatility suppression; or said even more simply, a regime that has forgotten about big bad wolves… But a Volatility Wolf Lurks.
This link between the Fed, artificially low volatility and rich premium sellers (carefree piggies) is undeniable. This was particularly evident in 2013, as QE3 (i.e. money printing) coincided with a 40% S&P rally and massively declining volatility. All that free money and “forward guidance” sure takes away anxiety.
But even when the QE spigot dried up toward the end of 2014 in the US, Europe’s ECB stepped in by 2015 and turned on a new spigot of trillions in printed Euros, much of which has been flowing back to US markets and thus continuing to keep the fear of that mean ol market wolf (and hence volatility) at bay yet again.
Given the record levels of central bank balance sheet expansion since 09 (trillions, and trillions, and trillions) and the record levels of low volatility for that same period, the correlation is fairly obvious. And with this low volatility, an entire cadre of emboldened (i.e. leveraged) volatility sellers has surfaced, all as happy, blithe, and fearless as those little piggies building straw and mud huts.
And can we blame them? After all, if global central banks are printing money out of thin air to buy time and make the world safe for premium gathering, it only makes sense to collect flood insurance premiums on homes that never see rain. Frankly, I can’t blame these guys for trading such a fat pitch.
But here’s the rub. What if the rain comes? Or to return to my original metaphor: what about the big bad market wolf—is he out there at all? Because if he is, selling puts to gather premiums will eventually get you eaten alive.
But talking about big bad wolves seems silly when the sun is shining so brightly (markets up, vol down) and premium gathering is making options traders even sunnier—i.e. wealthier. Right now, that trader building the brick house seems like such an old fuddy dudd, a real bore.
But maybe those ol bores quietly buying brick by brick of volatility know something the other little piggies have forgotten, namely the memories of 2000 or 2008 and the sound of that market wolf screaming at the front door of their portfolios: “I’ll huff and I’ll puff and I’ll blow your wealth down!”
That mean wolf is out there. Ask me when and how he’ll come back and I’ll tell you what the most experienced traders I know have told me. Namely: I don’t know. What I do know is that without central bank support, volatility would spike and markets would naturally fall rather than artificially inflate.
So what can we do or know today? What signs can we look for in this completely surreal, post-08 experiment of central bank artificial confidence, artificial highs, and artificial recoveries? A modest Fed rate hike in June will hardly invite the big bad wolf, nor would a modest macro slowdown this summer be able to threaten the false calm oozing from $20T+ in global central bank support and a recently positive US earnings season (more on that surrealism in a separate piece).
Just like in 2000, some of us feel the wolf approaching, but can’t find or name its catalyst or trigger. Then as now, there may be no “Lehman moment.” Elections in France have muted fears, and this is bullish, though problems in Italy could trigger more concerns on the EU. Banks in Europe are on a respirator, but that has been known for years.
Or maybe the bond market, after decades of bloating beyond precedent, just wakes up to the reality of getting no yield for risk and yells “sell!” one morning? Equities may just tank in dot.com fashion without any warning from that reliable ol Fed, who never once predicted a collapse. ETF distortions? The crazy rise of inflows into these passive vehicles can just as easily lead to an even crazier rise in outflows…Geopolitical risks? North Korea? Russia? DC? The Middle East? Impeachment/Special Prosecutors at the Oval Office? GDP stalling further (despite Trumps “really great” talk)? A loss of faith in central bank bedtime stories? The QE and ZIRP steroids dry up?
It’s hard to say. The list of risks is long, but the power of televised Wall Street peddlers, printed money, and low rates is undeniable.
Catalysts? Triggers? Frankly, who really knows? I’ve never seen a more distorted marketplace nor a harder one to predict—from AMZN’s share price to Italian sovereign yields. Even JP Morgan and BofA have analysts wringing their hands rather than waving pom-poms.
This market is over-valued yet could easily go higher. Money is flowing directly from overseas money printers at the ECB and into US markets. Central banks are running out of bonds to purchase and are now literally buying stocks as the addiction to artificial support runs wild from Switzerland to Tokyo.
These are artificially bullish trends, but bullish nevertheless.
So how might it end? Maybe if tax reform in the US fails, as many belt-way pundits, vote counters, and even economists here in DC predict, the wolf might come out of his cave as confidence in the US, arguably the best horse in the global glue factory, finally ends. There are many possible triggers.
I really don’t know how or when the wolf will show up. I’m amazed we’ve made it thus far. But I do know the long-term risks outweigh the near-term reward in these unprecedented and unnatural markets. Common sense and patience suggest we have our brick houses, MARKET SIGNALS, and portfolios ready when that howling sound once again rises from the woods.
Besides: I like to buy at near-bottoms, not at near-tops…