Distortions and Crazy Ideas
We have come across a few articles recently that discuss some of the strategies investors are using or contemplating to use as a result of the market distortions caused by current central bank policies. Readers have no doubt noticed that numerous inter-market correlations seem to have been suspended lately, and that many things are happening that superficially seem to make little sense (e.g. falling junk bond yields while defaults are surging; the yen rising since the BoJ adopted negative rates; stocks rising amid a persistent decline in earnings growth; bonds, gold and stocks moving in unison, etc., etc.).
Unknown veteran trader experiences another WTF moment.
Photo credit: Everett Collection
The investors engaging in said strategies all appear eager to court disaster in exchange for what seem rather paltry gains. To this it should also be pointed out that all sorts of trades are nowadays becoming “crowded” very quickly, often to a never before seen extent.
It’s like a bus full of children heading toward a cliff, with everybody 100% sure that the brakes are in working order, because supposedly skilled mechanics are in charge of overseeing the bus – the same mechanics who needlessly tuned up the engine (which has begun to make strange sounds).
The fact that said mechanics are known for groping in the dark most of the time is widely ignored, or let us rather say, it is actually widely acknowledged, but doesn’t keep people from making as if it didn’t matter. Why? Because of… TINA – the currently fashionable bubble rationalization.
Yield Engineering
One of these articles discusses a strategy currently employed by yield hunters. This may actually partly explain why the yen has been so strong – apparently foreign investors are piling into negative yielding Japanese government debt, which can be made to deliver a positive yield by means of financial engineering. According to a free lunch alert by Bloomberg:
It might be considered absurd, if not for the unprecedented contortions in global financial markets. Pacific Investment Management Co.’s largest international bond fund and China are piling into negative-yielding Japanese debt, buying securities that pay out less than the purchase price. And there’s a way to turn a tidy profit off the trade.
At the heart of the strategy is the world’s insatiable appetite for dollar assets, which is presenting an opportunity for investors with greenbacks to spare: the chance to pick up extra yield, a luxury in an era of record-low interest rates. For dollar lenders, even three-month Japanese bills, trading at a rate of negative 0.24 percent, offer juicy returns through a swap transaction that locks in exchange rates.
[…]
The trade is just one example of how unprecedented central-bank stimulus — from negative interest rates to bond buying — has pushed investors into uncharted territory. Consider that Swiss debt maturing in almost 50 years yields around zero, or that Unilever, the Anglo-Dutch consumer products maker, has securities due in 2020 yielding negative 0.19 percent.
A dollar-based investor needs just a few steps to turn Japanese three-month bill returns positive. To buy the bill, yielding negative 0.24 percent, a fund manager can borrow yen, lending dollars in return. As part of that agreement, they’d pay the three-month yen London Interbank Offered Rate — now at about negative 0.02 percent — and receive dollar Libor — at 0.82 percent.
But the trade becomes especially lucrative because of the basis spread on the cross-currency swap, which determines the cost to convert payments from one currency to another. The swelling appetite for dollars has led that spread to roughly double in the past year, to 64 basis points, or 0.64 percentage point, close to a 2011 high. The dollar lender also receives that amount. All in, the dollar-hedged yield on three-month Japanese bills is 1.24 percent, near the highest in at least five years, Bloomberg data show.
“This is a quasi-money-market trade, and it looks like a very efficient and appealing thing to do,” said Quentin Fitzsimmons, a money manager in the global fixed-income group in London at T. Rowe Price, which oversees $777 billion. “Yet that distortion has been present for quite a long time – it hasn’t been arbitraged away.”
(emphasis added)
Who can possibly resist that juicy 1.25% yield? – click to enlarge.
According to Bloomberg, such trades merely pose “reinvestment risk”, in case the yield becomes less juicy when the time comes to roll the trades over. To be sure, the way such trades are constructed, they have very little obvious risk. After all, every leg of the transaction is “locked in”, and the Japanese bills purchased are redeemed at par in a reasonably short time period.
So is it a free lunch? Not really – what the buyers earn, their counterparties lose. There is another problem, as we see it. This type of trade is becoming very crowded, and the key word here is “counterparties”. The longer this game goes on, the greater overall exposures will become, and the greater the potential for trouble at some point down the road becomes as well.
Not to forget, the Japanese government is sitting on a huge mountain of debt and the BoJ is currently engaged in an extreme monetary policy experiment. Moreover, Bloomberg notes that the method is lately used to buy longer term bonds as well, inter alia of issuers such as Morocco (of course, someone has to buy Moroccan debt). In short, this type of trade is spreading out into riskier market sectors.
Put Selling by Pension Funds
Another article on the topic of artificially boosting returns has been published in the WSJ. This one is discussing the decision by pension funds to begin writing puts on the S&P 500 Index, in order to “profit from fear”. We realize underfunded pension funds with completely unrealistic return expectations are desperate to generate additional income – we are just not quite sure what “fear” they actually want to profit from.
The VIX is currently so low, that a more inopportune moment to sell SPX puts can hardly be imagined. No wonder pension funds are thinking about it now. Someone’s got to be the patsy, and they often seem to volunteer – click to enlarge.
As the WSJ reports:
Some pension funds are seeking to profit from others’ fear. Pension funds in Hawaii and South Carolina are plying an arcane options strategy called cash-secured put writing. In a typical trade, the investor sells a contract, known as a put, to someone who owns stocks and is willing to pay up for protection in case they decline. If, within a certain time, the shares fall below a given price, the investor buys the stocks at that price, or covers their lost value.
The upside for the pension funds, which are writing options on the S&P 500 index, is that they earn regular income. The strategy aims to work like a volatility dampener. If stocks fall, the income the funds have collected on the options contracts should help cushion any hit they take on the puts and their own separate stockholdings. The pension funds set aside some cash-like instruments such as Treasuries for the payouts, so they aren’t caught without money if the market goes against them.
The cost of options tends to rise when investors expect big market swings, so the strategy does best when investors are fearful and paying up for protection against a downturn—and a downturn doesn’t materialize. But if protection is cheap and the market takes a big fall, the pension fund can end up with losses.
“There comes a point where you might be picking up pennies in front of a steamroller,” said Nathan Faber, vice president of investment strategies at Newfound Research, an investment manager that uses put writing, but not tied directly to the S&P 500.
(emphasis added)
Well, the point in time when “you might be picking up pennies in front of a steamroller” is actually right now. We are willing to bet that pension funds deciding to finally write puts on the SPX after it has rallied relentlessly since 2009 and implied volatility on SPX options has plunged to a multi-year low, are setting themselves up for a really painful “learning from experience” moment. It is likely to ultimately leave them even more underfunded.
Crushed Volatility and Unanimous Sentiment
Below we show a few charts that are illustrating just how risky the idea to write puts on the index right here and now is. In fact, pension funds should probably consider buying puts to hedge their portfolios, rather than writing them (the qualification “cash-secured” is meaningless – puts are always sold naked, so they have to put up margin).
First a set of charts from a recent Goldman Sachs research report. The authors are slightly perplexed that the market is refusing to price in any event risk in light of this year’s presidential election and the possibility that the Fed might deliver a second rate hike. One indication of this is the smooth shape of the S&P IV term structure:
SPX implied volatility term structure: no event risk is perceived to exist. This could turn out to be a major error – click to enlarge.
The next chart shows a 21 day moving average of the volume of SPX calls purchased over time. Since the BREXIT non-event, option traders have bought more SPX calls than ever before – by a sizable margin. In other words, everybody appears to be looking up.
SPX call purchases spike to historic highs. Note the timing of previous spikes – nearly all of these spikes were warning signs – click to enlarge.
This unanimous sentiment is confirmed by other data. The sentimentrader dumb/ smart money confidence spread has recently declined to levels close to the lowest readings on record:
A measure of speculative activity, mainly positioning data, pitting “smart” against “dumb” money traders. As you can see above, this spread has a pretty good record as a contrary indicator, even though it is slightly better at identifying lows than highs in bull markets – click to enlarge.
The next chart shows the SPX vs. the CBOE equity put-call ratio. Once again we can see clear signs of unusually pronounced post-Brexit complacency.
Equity option traders are also strongly focused on more upside – click to enlarge.
The next indicator is the most surprising though. Not so much in terms of the aggregate data, which have hit similar levels in the past, but in the disaggregated details which betray the current degree of trader conviction (or in this case, fund manager conviction).
We are referring to the NAAIM (National Association of Active Investment Managers) exposure index. First a chart of the aggregate index:
The aggregate NAAIM exposure index currently stands at 98.97%, which is among its highest readings historically – click to enlarge.
What is even more revealing though is the range of responses in the most recent survey. As NAAIM explains, possible responses can range between 200% net long and 200% net short (i.e., funds using leverage declare their degree of leverage as well). Here is a table showing the response ranges from the “most bearish” to the “most bullish” fund managers over recent weeks – we have highlighted the figures that are most interesting:
Range of responses of fund managers in the NAAIM survey about their net exposure to equities.
Not surprisingly, the most bullish managers are fully leveraged long at 200% net. What is truly astonishing though is what the “most bearish” fund managers have been doing lately. After still being 150% net short in the final week of June, their exposure quickly declined to zero, where it was stuck for three weeks.
In the most recent survey, the “most bearish” manager is actually 36% net long though. In short, there is not a single manager left who is betting on the market going down. We are not 100% certain, but we believe this has actually never happened before.
Finally, here is one more chart from the above mentioned Goldman Sachs report; this one shows the current Vega of VXX options as well as current open interest in VIX futures (we should add to this: speculators currently hold the largest net short position in VIX futures in history).
Vega describes the sensitivity of an option to changes in the volatility of the underlying asset. Since the underlying “asset” of VXX is volatility itself, VXX vega indicates the sensitivity of VXX options to the volatility of volatility. GS uses vega as a measure of exposure in this context.
VXX vega and VIX futures open interest – click to enlarge.
Finally, here is a bonus chart, which shows the price/sales ratio of the Dow Jones Composite Average (Industrials, Transports and Utilities combined) since 1994. This doesn’t really matter in terms of timing, but it serves as a good reminder of how hopelessly overvalued the market actually is.
DJ Composite price/sales since 1994. The current level is far above previous bubble peaks – click to enlarge.
Conclusion
Pension funds should refrain from selling SPX puts at this particular juncture. The strategy may have merit after a sell-off, when the VIX is actually at a high level. Currently put writing is apt to invite disaster. For the rest of us, the fact that they are considering the practice or have recently begun to implement it is yet another contrary indicator.
We should add that the market has given no price signals yet that would indicate it has peaked or is close to peaking. Only the divergences we have previously discussed (see “A Fully Automated Stock Market Blow-Off?” for details) remain in evidence. Moreover, US money supply growth (TMS-2) remains at a brisk 8.5% y/y as of July. Nevertheless, the current degree of complacency is extreme – all the more so in view of the fact that the world actually looks quite risky.
Charts and tables by: Bloomberg, StockCharts, Goldman Sachs, SentimenTrader, NAAIM