It’s not if, but rather when will a market pullback happen

We’ve had an extremely long run up in the market over the past month and a half.

The S&P 500 is up 8.8% since October 8. The market has barely had much of a pullback since this rally started. It feels like the market won’t pullback at any point soon. But it will happen.

There are a lot of questions to think about though when it comes to timing a pullback in prices:

How much long will markets run higher before the market pulls back?
What will the depth of the pullback be when it does happen?
What is the likely magnitude of the pullback?

These are all impossible to know, but are at least worth considering.

My prediction is that we experience a pullback sometime after December 20, 2019. Why that date? It’s the infamous quad witching date. What’s that?

What Is Quadruple Witching?

Quadruple witching refers to a date on which stock index futures, stock index options, stock options, and single stock futures expire simultaneously. While stock options contracts and index options expire on the third Friday of every month, all four asset classes expire simultaneously on the third Friday of March, June, September, and December.

Source

There is large gamma exposure coming off the books on this date. To the order of $2.7 billion. Source

There are the potential risks that could be a tipping point as well. If any catalysts materialize, a pullback is likely.

Possible risks include:

No trade deal with China, or worse, a more tense U.S.-China relationship.
Issues in the short-term funding market where the Fed can no longer control short-term interest rates
Bad guidance on future earnings
Declining GDP becoming more known

I believe a pullback could see much of gains up to this point being wiped out. $2900 isn’t out of the question of being tested at some point in mid-December to mid-January. That’d be down 7.7% from where we are currently at.

A deeper decline is possible, but would need to be closer before any thoughts about it happening.

I think a pullback could be very quick, 3-4 days like August and May pullbacks. Some even say it could be like February 2018 pullback, but I’m not so sure that the magnitude would reach that level.

With that being said, my predictions are usually wrong. Follow Murphy’s Law: Whatever can go wrong will go wrong. So make sure you hedge your bets and spread them out intelligently over some specified time frame.

BREAKING: Trump signs Hong Kong Bill

bbg hong kong

Donald Trump signed a bill into law that expresses U.S. support for Hong Kong protesters, a move that could strain relations with China and further complicate the president’s effort to come to a phase one trade deal.

Will the market react?

I would guess not. Gamma exposure right now is massive. This has held the markets higher for the past month, along with Fed interventions. If these are actually those items holding the market higher for the time being, we will see the current bull trend continue. This is where my bias is with about 65% probability.

How I document my trades

document

This is the format I’ve been using to track my options trades recently. As you can see, I show the Underlying Ticker, Type, Expiration Date, Strike(s) (multiple for spreads and such), Quantity, Cost per Contract, Cost Basis, Purchase Datetime, Underlying Price at Purchase, Open or Closed, Sale Datetime, Underlying Price at Sale, Sales Price per Contract, Sale Price, Profit/Loss, and Percent Return.

I’ve found with much of my data analysis, this is the ideal format for me with minimizes excess documentation.

One distinction with this is that I use the Open or Closed column to easily identify and match up trades on a First in First out basis (FIFO accounting).

I like having the purchase datetime exactly along with the price of the underlying stock to help review and analyze my entry and exit points within the greater context of the market.

How do you document your trades?

The World Has Gone Mad – Ray Dalio article summary

We are currently “pushing on a string”, a phase which Ray says we have never seen during our lifetimes. This is the situation where investors are flush with cash, and would rather invest it, not spend it.

The prices of financial assets have gone up as interest rates have plummeted. Low expected returns aren’t just driving up the prices bonds, but also equities, private equity, venture capital, etc.

Startups don’t have clear paths to profits, so they rely on selling dreams (Adam Neumann WeWork is a prime example) to get people to invest in their ideas. Investment managers are sitting on large hordes of cash and are looking for any place to park their funds, hence the overblown valuations of companies.

Government deficits are large and continue to grow. As a result, governments must sell more debt that nobody is interested in buying because the interest rates on these debts are so low. Central banks end up buying this debt by printing new money. (But don’t say they are monetizing the debt).

Down the road, as pension and healthcare liability payments come due, those obligated to make these payments will be unable to do so. How does this happen? Those institutions have expected returns of 7%, much greater than expected returns in the market in the coming years.

As these institutions are unable to make payments, unfunded liabilities will balloon as a result of suppressed growth. Teachers and governmental employees are those most exposed to this risk.

In sum, money is basically free (because of low to negative interest rates) for those who have money and creditworthiness. Money is unavailable for those without money or creditworthiness.

This contributes further to the wealth gaps we see today. Technological innovations are creating a way for companies to cut jobs further as well. The effects of low interest rate monetary policies are no longer “trickling down” to workers as a result. Thus explains how to we got where we are today.

Just because you see risks…doesn’t mean the market will price it in (yet)

I used to believe that risks to the market get priced into the market.

This is based off the efficient markets hypothesis. Once information is known it immediately gets priced into the market.

However, risks don’t always get priced in (right away) for one reason or another. Perhaps those risks are further off the horizon than believed. Perhaps those risks are going to dissipate soon. Perhaps those risks are not as significant as I believed they were.

Whatever the case may be, the market doesn’t always price in risks to the market right away.

Lesson learned

In October, I saw numerous risks to the market and strongly believed we would move down another leg lower in the S&P 500. I placed my bets accordingly, and it did not work out at all.

What risks did I see? A hiccup in the overnight repo market, beginning in mid-September. Hong Kong protests taking place every weekend, and U.S. Government officials denouncing China and supporting Hong Kong protestors. No signs of a real trade deal of significance. Slowing economic growth across the globe. A collaterialized loan market that’s looking more and more frothy.

I saw all of the risks, and here we are with the S&P 500 up 8.8% since October 8th, when the Fed made it known they would begin expanding their balance sheet with the purchase of Treasury Bills.

Markets are not efficient

Information can be priced in right away. Information can be ignored for days, weeks, months, or even years.

Risks can be priced in one week, and completely ignored the next week.

Markets are manipulated. No doubt about it.

But blaming my poor performance this month on market manipulation is irresponsible and definitely not a recipe for success.

I must learn how to trade around uncertainty and market manipulation caused by institutions and central banks across the world.

Trade the market you have, not the market you want.

Understanding the Kelly Criterion and Your Investment Decisions

According to Wikipedia:

Kelly bet is a formula for bet sizing that leads almost surely to higher wealth compared to any other strategy in the long run (i.e. the limit as the number of bets goes to infinity). The Kelly bet size is found by maximizing the expected value of the logarithm of wealth, which is equivalent to maximizing the expected geometric growth rate.

A Kelly bet is simply the optimal amount you should bet on a single trade (in my case) when you have some statistical edge (>50% chance with an even payoff) or some risk-to-reward payoff that pays off well despite low probability of success (e.g. a 30% likelihood trade that pays off 4 to 1 odds.)

Did the Federal Reserve Kill the Volatility Trade?

On October 11, 2019, the Federal Reserve announced they would begin buying Treasury Bills in an effort to ensure there are “ample reserves” in the banking system through the end of the year.

fed treasury oct 11

On October 11, 2019, the Volatility Index (VIX) sat at 17.4. Today on November 26, 2019 the VIX has recently closed at 11.5. As you can see from below, it appears as though this not-QE program that is “organically” growing the Federal Reserve’s balance sheet has effectively killed the long VIX trade.

fed vix chart

The case made that supports this idea is that investors are engaging in more risk on behavior, because they are basing their decisions based on the Federal Reserve’s prior balance sheet expansion programs (QE 1-3).

Because the Fed is purchasing T-bills, they have eased some of the money market pressures. Liquidity in the market has proven to be a positive catalyst to the market.

Why do I believe this?

It can’t be the trade deal.

That’s the only other source that has been moving the markets higher according to many daily stock market new reporters. And I don’t believe these markets are pushing higher on hopes of a trade deal.

I think the Fed’s easy money policies have once again eased tensions. For now.

A lesson to me

This whole scenario has taught me a valuable lesson about position sizing. I’ve learned to not be so overconfident in my predictions.

Every trade made is a small bet. Each bet will abide by the Kelly criterion.

Never go all in.

Grow your money slowly and strategically.

Live to trade another day.

Read

Barton_options on Twitter has been a great resource for me to learn more about the Federal Reserve operations and how it relates to the Treasury and the overall economy.

He recently wrote about this in a newsletter you can read here.

A Place for Scrap Notes and Scattered Thoughts

I will blog more often than I have in recent months.

The reason I haven’t blogged as much: I didn’t know what to do with this blog.

Until now.

I plan to use this blog as a place for scrap notes.

I plan to post thoughts and ideas that I come up with in the moment, and won’t focus so much on refining every piece of content I create.

A perfectionist fault

I try to make everything I create great. This prevents me from sharing many of my ideas as a result.

When I don’t have a fully formed, well-thought out observation, I don’t like to share it online. That’s why this blog is changing.

I want to get content out there as a means to force me to get comfortable putting content out there. It won’t always be pretty. It won’t always be polished. It won’t always be completely thought out. But it will be a place for me to document.

Every piece of content doesn’t have to be perfect all the time. This is a start.