Something strange is happening in the market right now

In the past few days, the S&P 500 (SPX) has risen to all-time highs. I mean, that’s strange given our current economic back drop. But that’s not what I’m talking about.

What’s strange about the current state of the market?

While the SPX is at all-time highs, the volatility indices have been rising as well. These indices include VIX, VVIX, and VXX.

If you don’t know what these are, that’s okay. VIX is an index that tracks the implied volatility of the SPX based off how the options for that index are priced. It is what the one month expected move in the market is, in a sense. VVIX is an index that tracks the implied volatility of VIX based off how the options on VIX are priced. VXX is an index that tracks the volatility based off the weighted balance of the first two VX futures contracts which trade.

For now, let’s focus on VIX. On August 25^th, VIX closed at 22. As of today’s close on August 31^st, it is 26.4. In percentage terms, VIX was up today 15%. (Many people don’t like quoting VIX changes in percentage terms — I don’t care).

In 3 of the past 4 days, we have seen VIX close higher than where it opened. This has happened all while the SPX has hit all-time highs in each of the past four days.

VVIX — also known as the volatility of volatility — has shown a similar trend to VIX, rising in 3 of the past 4 days. VXX — which is based off the front two months of futures contracts on VIX futures — has also steadily risen and shown similar trends.

Realized volatility is far below implied volatility options are pricing in

The volatility that is implied by SPX options is much higher than the realized volatility we’ve seen in the past 30 days. According to my calculations, realized volatility for the past month has been under 10%. Meanwhile, VIX has held strong above 22, and has continued to climb in recent days as noted above.

Why is this strange to me?

In general, you tend to see VIX fall as SPX rises. In general, there is an inverse relationship between these two items.

Today, VIX rose by 15% while SPX fell by roughly 0.3%. According to my data, this has only happened 5 times going back to 1993.

Note: The above chart is in percentage terms.

I’m not the only one that has noticed

Mark Sebastian, from OptionPit.com and frequent guest on The Options Insider Radio noted the following:

What he is saying here is that there is a huge difference between the volatility being priced the NASDAQ 100 Volatility Index — VXN — and the S&P 500 Volatility Index — VIX. This is interesting to me because the NASDAQ 100 is composed of non-financial companies and is weighted heavily towards those tech stocks. The very tech stocks which have been going parabolic in recent weeks (some may even say months).

In addition, Matt Thompson noted the following:

The 5-day average contango, which is merely the difference in the implied volatility priced in by the front month futures contract and the second month futures contract is at 16.9%, which was at the 99^th percentile since 2004. Also he noted what I noted earlier, that the VIX is much higher than the realized volatility on SPX.

What does this all mean?

This could mean a number of things. Ultimately it means there is a lot of uncertainty in the market, and options are pricing in more volatility than the volatility that we’ve witnessed in the last month.

This could mean that big money is hedging their positions with put options on SPX or call options on VIX or buying VX futures, all of which could cause the premiums paid to rise.

In addition, the VX futures for October are pricing in extra volatility due to the upcoming election. The pricing of these October futures remains elevated when compared to the September and November VX futures prices.

Investors are nervous about what could come in the next month or two. And they have good reason to be.

There is still no agreement on extended economic stimulus that the American people desperately need. Republicans and Democrats have still not agreed to a deal. As of the last update I saw, Republicans proposed a $1.3 trillion stimulus, which was rejected by Democrats. The House, led by Democrats, passed a $3 trillion stimulus back in May. They said they would be willing to lower their demands to $2.2 trillion. No deal is in sight, and that could have investors spooked.

Fact is, we are in a bubble

The last time market closed at all-time highs with VIX this elevated was during the late 90s tech boom. That was a time period which also coincided with easy Federal Reserve monetary policy and high speculation in stocks.

We are seeing similar behavior in the tech stocks and work-from-home stocks today. Apple, Amazon, Google, Facebook, Tesla, Nvidia, Zoom, and AMD are all examples of stocks which are booming right now.

But the pain for the American people is far from over. Continuing claims continue to remain above 14 million. The unemployment rate is over 10%. The economy is attempting to recover slowly. But stocks? They’ve ripped to all-time highs at a much more rapid rate. And the disconnect between those two has investors nervous right now.

Dark pools are not buying this rally anymore either

In order to understand what’s happening, check out the Dark Pools. According to the Dark Pool Index over at Squeezemetrics.com, Dark Pools have printed under 45% for 17 days in a row. In general, a print over 45% is considered to be bullish, and there tends to be a slight lag between dark pool prints and stock market returns.

This is meaningful to me because Dark Pools bought the rally all through April well into July. But they aren’t buying anymore.

Perhaps we will begin to see a return of selling to the market in the coming days or weeks. I know I’m on high alert for that right now and will be ready to short this market when the opportunity presents itself.

What are Federal Reserve repo operations?

Repo operations (within the context of the Federal Reserve) are Repurchase agreements and are conducted only with primary dealers.

The Fed purchases Treasury, agency debt, or agency mortgage-backed securities from a counterparty, subject to an agreement to resell the securities at a later time.

It’s similar to having a loan that is collateralized with assets. These assets from the banks have a higher value than the loan to protect the Fed against market and credit risk.

Repo transaction temporarily increase the quantity of reserves in the banking system.

The New York Fed began conducting repo operations in September 2019 to ensure supply of reserves is ample and to mitigate risks of money market pressures near year-end that could affect policy implementation of interest rates.

What is a repo?

Repo is a generic name for repurchase transactions (which can include buying or selling). It is a transaction in which one party sells an asset (such as Treasury Bonds) to another party at a set price and commits to repurchase the same assets from the same party at some future date.

If the seller defaults, the buyer is free to sell that asset to a third party to offset their loss. This is what makes a repo very similar to a collateralized or secured deposit.

How is repo rate determined?

The difference between the price paid by the buyer at the start of the repo and the price received at the end is effectively the lending rate on the repo. This is known as the repo rate or repo interest.

Why are repurchase agreements (repos) used?

Repurchase agreements can serve four different functions for various market participants:

They are a safe investment
Borrowing costs on repos are very cheap
Yields can be enhanced for those holding a large amount of safer assets
They provides a means for short-selling and short-covering

It’s safe because the cash is secured by collateral, which is generally safe assets. Makes it easy for seller of repo to make money back by selling those secured assets.

Yields are enhanced because a party could lend out a high demand asset to the market, and in return they receive cash for cheap which can be used for funding or reinvesting profits.

Why do banks use repos?

Banks will use repurchase agreements (repos) for short-term borrowing. They do this to raise short-term capital and generally use agreements which are very short-term, generally overnight or 48 hours.

The implicit interest rates on these agreements is known as the repo rate, and is a proxy for the overnight risk-free rate.

Repo can be used for many purposes. One such purpose would be as an efficient source of short-term funding

It also allows institutional investors to meet liquidity requirements without having to liquidate long-term investments. The repo market has become an important source of cash for non-banks to meet Basel regulatory requirements.

The World has Gone Mad – Ray Dalio Article Summary

Two months ago Ray Dalio wrote an article on how the world has gone mad with regards to monetary policy. Here is my short summary of Mr. Dalio’s article:

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.

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.

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.

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.

Stocks have recovered too quickly

SPY was up almost 2% today, erasing all of this weeks losses generated on Monday. Not only did SPY close the gap, but at this point we are up 36 basis points from last Friday’s close.

After a decline of nearly 7% off of its high, SPY has gained 4.2%.

We have exceeded a 50% Fibonacci retracement, and are very close to a 61.8% retracement from the all-time highs set in late-July.

Overbought conditions were reached on the RSI indicator, using 30 minute candlesticks as seen below. Peak overbought conditions were seen today around 12:30 pm.

SPY was moving sideways for a few hours later in the day, but broke higher in the final hour of the day.

In the last two days alone, from it’s bottom at the open yesterday, SPY has gained over 4%.

In my opinion, Monday was sold off too quickly and this recovery this week has also happened too quickly.

VIX hit the support level around 17 that I had set out in my post yesterday as a level to watch for. I think this line will continue to act as support and VIX will bounce going into close tomorrow.

VIX didn’t really sell off much on the 6th which surprised me. Some say that big money was picking up volatility options at this time.

If so, VIX getting sold off would make sense to me if options traders were taking profits on their trades Monday and Tuesday. The reason I think it makes sense is because when those market makers buy the puts, they are also going to have to buy the underlying stock to remain delta neutral.

I think you see adjustments from market makers impacting the markets. I also believe that today was more of a short squeeze combined with unwinding of VIX call option/SPY put option positions which jerked the market around in these past couple of days.

As those positions are done unwinding, which I think will happen in the next day or two, I think it’s likely that the market will continue to selloff and VIX will spike once again.

The risk hasn’t changed in three days

We’re still in a trade war with China.

Tariffs are still slapped on China.

China still isn’t buying US agriculture.

The yield curve is still very much inverted.

Central banks are turning to easy money policies.

Risk isn’t off right now. Have a small position in volatility and protect yourself against the turmoil.

The sell-off is not completed

Investors must now price in additional tariffs on China, and further conflict going forward with regards to China.

We won’t have a trade deal anytime soon. It’ll take a while for the repricing of assets to trickle through the market, just like it did back in May.

As I mentioned earlier, I expect IWM to pullback 5-7% since it broke the $153.50 support level earlier today.

SPY is a little trickier for me. It tends to whipsaw in price when volatility picks up, possibly due to algorithmic and HF trading. I think we see SPY revisit $285 range before the end of next week (Aug 9 expiry), but it’ll be a rocky ride.

I think VIX will also whipsaw next week, seeing a range with a low 14.7 and all the way up to 23.5. That’s just my guess.

However, a quick resolution on China trade would negate this scenario.

Why should you expect market volatility to rise in the coming days?

Whenever the Federal Reserve holds a meeting, markets are on edge.

So many investment models must take into account risk-free discount rates, those rates based off Federal Reserve policies. As a result, pricing adjustments always take place around important Federal Reserve meetings.

Investors adjust those models based off what they believe discount rates will be in the future. This month, many investors have priced in a rate cut.

Speculation

If the Federal Reserve doesn’t cut rates I think the market will be disappointed and will sell off.

If the Federal Reserve does cut rates, I think the market will be optimistic (more than they already are), stocks will get a boost, and treasuries and gold will surge.

I don’t believe volatility will stay low this week. VIX is sitting at 13.2 as of now just before market open on July 23rd 2019.

In July, VIX bottomed out around 12.4. It’s bounced off this support line a couple of times this month. It’s surged over 14.5 on a couple of occasions. I think following the Federal Reserve meeting VIX will climb up to 15 or possibly over 17 by the end of the week.

That’s what I think. How about you?