TRANSCRIPTION: IN-DEPTH - THE PASSIVE ETF DYNAMO
To understand the insanity we are presently witnessing, we need take a step back and consider just how institutional money like Pensions, Insurance Companies & Financial Intermediaries think.
- They like fixed income because it's far less volatile and ostensibly less risky than equities,
- They hate small caps and frankly can't invest in them due to their size, and they have a disdain for commodity markets. That volatility thing again...
- Volatility is like a barometer in their world by which everything else is measured,
- The problem is with the central banks untested interest rate policies of QE, QQE, ZIRP, NIRP and Operation Twist, none of the institutions have been able to make sufficient money without accepting too high a risk/reward profile. So what are they doing in a yield starved world --- wait for it --- their selling volatility!
They are doing this either through tailor made products from the investment banks or by buying any number of the low volatility Exchange Traded Products (ETPs) out there. Volatility isn't even an asset or an asset class - but it appears to becoming one!
The hard reality is that the VIX is an index of volatility on 1 month to expiry ATM puts and calls on stocks in the S&P 500.
Over the last three years the geniuses on Wall Street have figured that they can actually package this animal, which as you can see is:
A Derivative of a Derivative which is then they treat it like a bond!
I ram reminded of a similar illusion in the run up to the 2008 crisis where CDS' were used to transform high risk junk debt into acceptable Triple AAA institutional debt instruments.
Frankly, hats off to the asset managers who've had the creative, courage and 'shoutsba' to do this! They believed in the central banks' liquidity machine, and they backed their belief and for that they deserve to be paid. However, it doesn't make it even close to a sound investment strategy!
What we do know is that this entire game of the selling of volatility via passive indexing is that all of it is predicated on one thing.
Central banks keeping rates low and pumping liquidity into the market.
It's why BTFD has become the meme.
The problem that I have with it, other than the many distortions caused by it, is that when so many are on one side of the boat as they are now with that boat has many moving pieces, then I get nervous and look for the life boat - just in case.
I'm reminded that markets change at the margin, where the slightest hiccup can act like a spark to light the fire of volatility, and these poor institutions who've managed to earn steady incomes selling puts find out what "unlimited risk" actually looks like as they're forced to cover in a market that's are "gapping" the other way.
Volatility across asset classes has decoupled from uncertainty. Even if seemingly irrational, apathy to all risk has been the right trade and an impossible trend for most to fight – the definition of a bubble.
But as the classic and generally reliable ending diagonal suggests - it may not last too much longer!
According to -- BofAML's Derivatives expert Benjamin Bowler
"While there is active debate about whether risk-assets like equities and credit are overvalued, it is much harder to argue that currently depressed volatility levels are unsustainable when near 100 year records in terms of low volaltility and the lack of persistence of any shock are being recorded."
As shown here, the VIX is near 26 year lows despite political & policy uncertainty recently near 26 year highs.
What is not fully recognized is that 90 year records are occurring in the speed which US equities are recovering from any and all dips - as few as they are becoming!
What is happening is -- VOLATILITY IS BEING SOLD!
Over the last six months, VIX has spent more than 40 days below 10. Putting this staggering outlier in context, the index has never managed to accumulate more than 6 days that low, measured over the same time interval, over the last 30 years. As I recently read:
"why buy volatility if you believe that any selloff is impeded by a central bank backstop?"
In fact (as we will get into it in a moment) - "Implied volatility is sailing in the same uncharted waters as corporate credit".
Let me lay out, as graphically shown here, a road-map for our discussion.
First, let's talk further on what is driving extreme low volatility in such turbulent times, then discuss corporate credit via Junk Bonds, then margin & leverage and finally tie them altogether with some observations on the explosion in passive ETFs.
I suspect this will be the road-map of what is in-store for us going forward during the inevitable the coming market correction (or minimally consolidation if you believe markets are headed higher).
A little history may be in order here. My observations which the BoAML recently graphically annotated in this chart are that:
- TAPER TANTRUM: Investor reaction to the Fed announcement of plans to slowly stop Quantitative Easing (QE) in July 2013 resulted in the markets "Taper Tantrum" and forced a reaction of coordinated G4 central bank intervention. The four central banks I often refer to as the "Currency Cartel" - The Fed, ECB, BOJ and BoE which control 95% of current daily currency trading.
- CHINESE DEVALUATION: In August 2015 China shocked the market with a Currency devaluation which led to the Shanghai Accord (which I did a number of videos on at the time) where Fed Governor Janet Yellen "decided" (or was forced) not to raise rates due to what she then public articulated as due to “weak equities” (when they were only down approximately 10% from all time highs).
- BREXIT: Subsequently, when the Brexit vote shocked the markets in June 2016 it marked the inflection point when the "buy-the-dip" trade became a self-fulfilling PUT since Yellen signaled she would move more slowly with rate hikes because of Brexit "fall-out concerns". BofAML cited the same observation and referred to it as the initiation of "Dip Alpha" program trading.
All of this has resulted in a Fed "PUT" Strike Price. But..
WHAT IS THE FED’S “PUT” STRIKE PRICE?
What we do know is that we have an:
- Untested Strike Price as “Buy the Dip” Buying is assuming the Fed Will Step in.
- The Strike Price is falling as Fed Raises Rates and rebuilds ammunition.
- As a consequence the Fed will accept more risk as it recognizes that markets can better stand on their own.
The Fed & Central Bankers Need a Shock to Test What it Now Is!
In this world of record high valuations and record low volatility, in which the market no longer responds to news, shocks or risks, and in which nobody dares to point out the obvious - that this is the biggest asset bubble in history - There seems to be just one trade!
- Low Risk Premia,
- Low Level of Volatility,
- Lack of Responsiveness to Tail Risk,
- Spillover of Systemic Events,
- The Reluctance to Sell,
- Extreme Valuations,
….. are merely symptoms.
The central question is what are the skewed incentive structures resulting from this Fed backstop doing to the fabric of markets - after so many years.
It appears that trades and strategies which explicitly or implicitly rely on the low-volatility environment continuing...
..... are becoming more and more ubiquitous!
This graphic is a representation of how Citi Group Research presently sees what is going on in this self reinforcing trading pattern. In a world without market shocks, volatility continues to decline, forcing even more volatility selling, in a self-reinforcing feedback loop! Low volatility means falling Value-at-Risk and rising Sharpe ratios. This fosters higher risk limits for institutions. More inflows accept risky assets.
In the way of clarification...
- Value at risk (VaR) is a statistical technique broadly used by Financial Institutions to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. ... VaR calculations can be applied to specific positions or portfolios as a whole or to measure firm-wide risk exposure.
- The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return then the performance associated with risk-taking activities can be isolated.
This is what drives Institutional thinking.
Frankly, clever to the point of being stupid!
The immediate result of this dynamic has been two-fold:
i) Investors now buy every dip, or as Bank of America notes, "Investors no longer fear shocks, but love them, as it is an opportunity to predictably generate alpha.", and
ii) Selling of volatility has become a self-reinforcing dynamic, in which lower VIX begets more volatility-selling by "yield-starved investors", leading to even lower VIX as the shock that can reset the feedback loop is no longer possible, and thus the strike price on the Fed's put can not be put to a market test.
WE ARE LIKELY ON AUTO PILOT UNTIL THE INEVITABLE SHOCK HITS!
“There is a clear risk that the 2017 low volatility environment carries on through 2018, which is more likely if inflation were to fail to rise, prolonging the current goldilocks period.
- The Fed could continue to slowly plod along with hikes, and absent a sufficient exogenous shock, the market may maintain full faith that they could pause (or cut) if needed.
- Equities would again generate exceptional Sharpe ratios, beating almost any other asset, as we saw this year.
- As US equities recorded nearly their highest Sharpe in history this year (the Dow Jones Industrials recorded a Sharpe of 4, 99th %-ile since 1935), the chance of this repeating yet again may be lower than some expect.
The KEY DRIVER OF THIS MARKET is Central Bank Asset Purchases
- Trades and strategies have been built up around an assumption of the status quo,
- The inflection point if / when it comes will be anything but smooth and linear,
- The longer we remain in the current paradigm, the greater the chance that it ends up being both sharp and painful.
A wise man observed:
“In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”
Markets and trading strategies have not factored in the major Central Banks plans for:
- Normalization in the US,
- Taper in the EU nor
- Tightening in Japan (via reduced ETF purchases) or
- Tightening in China via crackdowns on Shadow Bank lending.
To a large extent (as the yield curve reflects) - Institutional investor simply don't believe the central Banks will follow through and an aging business and credit cycle are really the controllers to watch!
THE CENTRAL BANKERS FEEL THEY ARE LOSING CONTROL
They will probably be forced to go further tan most appreciate because besides the yield curve even key indicators like the Financial Conditions Index are going the wrong way - or simply not paying attention to the Central Bankers "jawboning".
POTENTIAL SHOCKS ARE ENDLESS
- Central Banker Liquidity,
- Presidential Impeachment (Trump Rally Retracement),
"The "biggest vulnerability lies in assumption of the status quo ... and markets have not reflected change in paradigm."
Lets move to the Corporate Credit Market and specifically high yield corporate credit.
The desperate global search by Institutions for yield has driven credit spreads to historical low. Levels usually occurring around or precipitating a crisis. I have never seen spreads this low with as many potential clearly evident market risks (our Deutsche Bank list of 30) which are not priced in and additionally could significantly change the spread dramatically. Headline risk is simply not a consideration anymore. We have dumb money blindly following (or being forced to follow the heard)!
There is little question from a timing standpoint alone, we are long overdue for some sort of violent adjustment. Identifying what it will be is a fools mission and is basically irrelevant.
Only the probability of such an event occurring needs to be assessed.
Remember, when it occur you will not have time to exit. It is my opinion (and we will get to that) liquidity will at that moment disappear in a "heartbeat"! I have seen this many times before.
That takes us to the margin debt and leverage supporting all this.
Margin Debt growth on the NYSE is now outstripping the S&P 500 growth. This is highly unusual and certainly has never been sustained for any period of time.
Especially when margin debt net credit balances are historically so low!
The 2% “danger signal” was something Alan Newman at CrossCurrents concocted many years ago, after seeing total margin debt peak around 2% of market cap in 1987, just before the Crash.
Since 2010, every year has been above the 2% level. More importantly, he began measuring total margin debt versus GDP during the tech mania and believe it is a vastly more significant measure; better able to detect periods of excessive leverage.
Personally, I think this graphic puts the excess leverage into perspective. Total System Leverage (Government, Corporations, Households, Margin and Banks) is clearly driving the lift in stock prices. As our recent UnderTheLens video addressed - how good is the underlying collateral supporting this credit edifice?
Finally, for the sake of time let's talk about Passive ETF growth. This itself is a huge discussion which I am going to have to leave in total for another day.
Suffice it to say that Global institutional pension fund assets in 22 major markets stood at US$36.4 trillion at year end 2016, amounting to 62% of global GDP.
That is a staggeringly large amount of money. Pension & Institutional funds are big cumbersome dumb money. And they're all now, more and more, allocated in equally dumb indexes, passive strategies, and bonds.
The passive bubble is growing bigger as I write this because this beast is fuelled not just by all Wall Street but increasingly by the average investor getting back into the market as they are afraid of missing out. Consider this recent New York Times article headline "Signs Of The Peak - Former Target Store Manager Makes Millions Day Trading Volatility From His Bedroom".
You always get these sort of headlines as market tops approach.
Bloomberg just ran a piece:
Two towers of power are dominating the future of investing.Dominating indeed. Here's how come the Wall Street pointy shoed crowd can afford Tom Ford suits.
Investors from individuals to large institutions such as pension and hedge funds have flocked to this duo, won over in part by their low-cost funds and breadth of offerings. The proliferation of exchange-traded funds is supercharging these firms and will likely continue to do so.
These behemoths don't do battle in the little unloved sectors or with stocks that don't make it into an index. They can't because they're too big.
Here's the competition in active versus passive funds.
Right now, it's a mosh pit food fight to grab and create the next index or ETF so that more capital can be attracted, earning more fees, buying more suits.
This is all well and good.
Markets do what markets do, and I'm not here to grumble about it. I'm here to make money. And indeed if I was in the passive business, I'd be enjoying the steady stream of fees and hoping like hell the market keeps going up.
QE more? Yes, please.
Stocks in the index funds no longer trade on fundamentals but rather on asset flows, which (by the way) sucks the oxygen out of the small guys who don't make it into the indexes where
brain dead passive money is playing.
Ask yourself: "what happens when pensioners start drawing down on their funds?" The reality is global "baby boomers" are now retiring - at approximately 10,000 per day in the US alone.
Here a typical ETF chart - this one of Barclays HIgh Yield Bond ETF. I have annotated it to show how it has been completely supported by Central Bank liquidity programs.
It is hanging on by a thread, as volume is now slowing. When and if the fall comes it will be dramatic!
I remember during the financial crisis when the Federal Money Market Fund "broke the buck". Corporate CFO's prudently began shifting money by the click of a mouse into short term Treasury Bills. $5T in one afternoon sent the US Treasury Secretary and Fed Chairman to the Congress that night in near complete panic.
The whole idea behind ETF's is diversification with ready liquidity. However, there is no liquidity and the pricing of ETF products calculates that against you if you are able to exit. If you can't (and I see this to be the coming reality) it will be even worse than you can imagine and likely of historic consequences.
Consider yourself warned!
THE BIG SHOCK
NOTHING IS GOING TO HAPPEN WHEN EVERYONE PUSHES THE BUTTON