Common Cents for February 9, 2018

February 9, 2018, by John Norris

Section I

We have all heard the old adage “don’t put all of your eggs in one basket,” and instinctively know what it means. In the investment industry, we have a fancy name for this particular old saw: diversification. You buy a few shares of this, a couple more of that, and a fistful of ‘those over there’ to hopefully ensure you have something going up when the markets rally AND that not everything ends up in the ditch when they fall apart.

Over my career, I have seen any number of new products emerge, as though out of the ether, in order to help investors mitigate their downside risk. To be sure, there is no shortage of exciting new investment vehicles seemingly every week; each purporting to be a better mousetrap or even more effective way to skin the proverbial cat. Truthfully, a lot of this stuff is too clever by half, and to think international equities were considered kind of, well, sexy when I started in the industry.

For long years, the next best thing was tied to a tangible, but overlooked, asset class or sector. Then, I don’t know, about a decade or so ago, the financial alchemists who cook up these things started packaging what amount to be side bets, bets on bets on top of bets. And why not? They were just another way of diversifying an already diversified investment portfolio. No correlation here? No correlation there? Work in all markets? What the heck?

In 2017, the fair-haired, slam dunk next new things were funds/notes which ‘shorted volatility.’ Put another way, they moved the opposite direction of the VIX (CBOE Volatility Index). What in the heck is that? Well, the VIX is…gosh…let me give you how the CBOE tries to explain the calculation on its website:

“The Cboe Volatility Index® (VIX)® is based on the S&P 500® Index (SPX), the core index for U.S. equities, and estimates expected volatility by averaging the weighted prices of SPX puts and calls over a wide range of strike prices. By supplying a script for replicating volatility exposure with a portfolio of SPX options, this new methodology transformed VIX from an abstract concept into a practical standard for trading and hedging volatility. In 2014 Cboe enhanced the VIX Index to include series of SPX Weekly options. The inclusion of SPX Weeklys allows the VIX Index to be calculated with S&P 500 Index option series that most precisely match the 30-day target timeframe for expected volatility that the VIX Index is intended to represent. Using SPX options with more than 23 days and less than 37 days to expiration ensures that the VIX Index will always reflect an interpolation of two points along the S&P 500 volatility term structure.”

There you have it. The VIX tracks the direction of the derivatives tracking the S&P 500. So, a fund which, for all intents and purposes, shorts the VIX would have to be using derivatives on top of derivatives. Basically, it is taking the other side of the side bet.

In this situation, the VIX (or volatility) essentially goes up when the market goes down. So, shorting volatility is in a lot of ways the same as being long the stock market, as least directionally. I suppose you could achieve the same basic end by levering up and going long bullish S&P futures. However, as complicated as that may sound, it doesn’t sound anywhere near as clever as ‘shorting-volatility.’ So, perhaps…maybe…you could argue these types of products package marketing spin? Hmmm?

Well, that last paragraph might be a little bit of an oversimplification. However, there is enough veracity in there for argument. But, so what?

If have read anything in the news this week, you have probably read something along the lines of: “we have not changed our fundamental forecast for the economy or the markets in 2018. However, we can’t predict the short-term bottom of this market.” This has basically become the industry manta….om…om…om.

The reason being is kind of simple: everyone means it. You see, we had a couple of ‘short-volatility’ funds blow up at the beginning of the week after last week’s big blow-off following a ridiculous January. This/that is sort of new ground for the investment industry. Why? Read how a certain Trey Henninger put it in an extremely well-written, informative article:

“The XIV fund along with its fellow short volatility funds like SVXY were *Short* volatility futures. I know this is a given, but it’s important. Because XIV was short the futures, they were forced to buy back a huge number of futures contracts after the stock market closed in order to cover their short position. According to Pravit C on Twitter courtesy of Robin Wigglesworth, XIV and SVXY had to purchase approximately 200,000 VIX futures contracts.

That is the definition of a short squeeze.

Unfortunately, that means other people sold 200,000 VIX futures contracts in that time frame. Those futures contracts are the spark that lights the fire of my cascading effect proposal.

In order to arbitrage away the risk of those 200,000 VIX futures contracts, the sellers will need to sell options against the SPY or other S&P 500 index proxies. Alternatively, they can sell stocks in the S&P 500 directly. In fact, they can use any of the three other methods mentioned above, in order to reduce their risk. They’ll likely use all three.

What all of this means is a massive flood of selling pressure will begin to enter the stock futures market starting today. This futures selling can then create follow-on effects in the actual stock market, leading to a massive stock market crash.

This forced liquidation of XIV could then function very similarly to the portfolio insurance phenomenon that caused the -22% single-day drop in October 1987 on Black Monday. Forced selling will feed more forced selling, and the sheer volume of sell orders can overwhelm the available buying liquidity.”

That is how a side bet can impact the real deal. Of course, this can be a vicious cycle: this nonsense driven sell-off forces margin calls in long accounts which triggers quant traders and so on. In so many words, this type of short-term panic often squeezes a decent amount of leverage and [effluent] out of the markets, which can be a good thing. However, the concern is always the markets will proverbially ‘throw out the baby with the bath water.’ Will it dry up TOO much excess liquidity in the financial markets, etc.?

At this point, it is too early to tell. On the flipside, again at this point, it hasn’t, and the underlying fundamentals of the US economy remain strong. Historically, this has bode well for stock prices. Whew. Admittedly, this is some really nerdy stuff, but you should expect as much from a newsletter about asset diversification.

Upon rereading this, let me close with this: our investment strategy group is going to meet at the beginning of next week to discuss selling some fixed income to redeploy into stocks. While we haven’t yet made a firm decision, literally and figuratively, at some point enough is enough.

 

Section II

Recently, the markets have been all aflutter about the potential for inflation. While we all know the definition of inflation, what does it mean? For me, my baseline is the double-digits of the Carter Administration years. However, I will be 50 in a few months, and am older than the vast majority of the folks physically sitting at trading desks/stations around the world who move the real money on the matter. To them, inflation might be 4-5%. Heck, it might even be 3-4% after all these years of China’s overcapacity-led, global disinflation.

I suppose you could say we will know inflation when we see it, or something along those lines. Or will we?

As I type this, I have ear buds stuffed in my auditory canal, and have just finished listening to “The Ghost in You” by the Psychedelic Furs. I added the song to my iCloud library last night while working on a playlist I named ‘Commonwealth Pop.’ It is chock a block full of saccharine sweet tunes I didn’t admit to liking back in the day. These days, who cares?

In any event, I didn’t spend an inordinate of time or money on music growing up, at least when compared to much of my peer group. To that end, I don’t remember ever making what we called ‘mixed tapes,’ and my record/cassette collection wasn’t quite as large as many others. Frankly, I was too cheap with my money, and the radio was (still is) free.

These days, I am still pretty stingy when it comes to paying for music, but I have never spent more on it in my life. You see, a few months ago, I signed us up for the family plan on Apple music. It costs $14.99/month, which works out to be about $180/year. Even when I adjust for inflation in my head, yeah, I didn’t spend that in high school. Why now? Here on the cusp of the half-century mark?

Okay…here is where it gets kind of weird. You see, while I have never spent more, music has never been cheaper. So, it is both kind of inflationary and deflationary at the same for me, as a consumer. If that doesn’t quite make sense, let me explain or try to do so.

A couple of days ago, I had the song “Take Me with U” by Prince stuck in my head, an earworm if you will. Now, Prince never made a dime off of me while he was alive. While I liked a few of his tunes, I didn’t like enough of them to purchase a whole album or cassette, and I wasn’t a huge fan of 45s. These days? Shoot, I pay $14.99/month for access to just about any song I can possibly imagine. If I want to hear “Take Me with U,” you know something? I will just get the whole dern album, and I did.

Where the rubber meets the road, 33 years after its release, I finally got “Purple Rain.”

I also got a lot of other tunes this week I would have never purchased BUT FOR the fact I have never spent more on music because it is so cheap. Here goes a few of the groups: The Cure; Big Country; The Icicle Works; Naked Eyes; OMD; Simple Minds; The Verve; Pet Shop Boys; The Church; Echo & The Bunnymen; The Vapors; The Psychedelic Furs; General Public; Modern English, and Thompson Twins. Individually? Maybe 1-2-3 songs a piece, spread over just as many albums in yesteryear. In 2018? A tidy 2-hour playlist of old-school British pop I would never have had, which took me all of about 45 minutes to compile. As an aside, older ears aren’t big fans of Adam & the Ants. Enough said.

Soooo….that is an example of inflation which doesn’t show up in the official numbers or in the hedging strategies of 30-somethings across the globe. Do you want another one? Well, maybe just one more if you insist.

I like to cook, and used to make a pretty mean lasagna. That is until my wife made one about 75% as good as mine with about 33% of the effort and cost. Regardless, go find a recipe for the stuff from a relatively old cookbook, if you have one. I will wait here…

Okay, what did you find? Did it call for a 16 ounce can of tomatoes? It did, did it? How did I know that? Well, I suppose I was just lucky. However, I am going to ask you to do another quick favor for me: go to the closest grocery and buy a 16 ounce can of tomatoes. How much does it cost? Again, I will wait here…

Are you back yet? Okay, how much was it? What? You couldn’t find one? All they had were 14.5 ounce cans out? And you even asked if they had any in the back? Hmm. I figured as much.

You see, it isn’t all that uncommon for producers to sell smaller sizes but charge the same amount. Have you ever come home with a 1-lb. package of bacon which actually only weighed 12 ounces? Why does my Stella Artois only have 11.8 ounces? They sell enough here in the US as to warrant a 12 ounce variety, don’t they? Also, when did the small pizza become a large and the large an extra-large? Why does the medium shirt cost as much as the XXL? Have you ever paid up for the all you can eat whatever, only to fill up on salad and breadsticks? Join the club.

All of this inflationary as well, as it costs more money to get the same amount. However, it doesn’t show up in the CPI, because the CPI tracks unit cost, and the unit is a can of tomatoes. That is what is in the basket, and they substitute the heck out of the items in the basket.

For instance, I like lamb, but I never buy it because it is too expensive for what I get. If I want red meat, I opt for beef instead. Using the prevailing methodology, ‘they’ remove the higher priced lamb and replace it with beef. If beef gets too pricey, and I start buying potted meat, guess what? They will put the latter in the calculation. The end result? Red meat protein is now out of my price range, but hasn’t gone up much in price.

Of course, that is a simplistic example which would never completely happen, but it good enough for government work…which is incidentally what calculating inflation actually is. There is a point to all of this.

Regardless of the markets’ collective fear of inflation, whatever it may be, inflation is/was already all around us, and always has been. Sometimes you just have to open your eyes and expand your definition to find it.

 

Take care, and have a great weekend.