Haymaker - A Last-Minute Audible

And More from the MacroTourist

“Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.” - Rule #4 from Bob Farrell’s ‘Market Rules to Remember’

Today’s guest note, which we are sharing in excerpted form, by the prolific Kevin Muir is not the one we originally intended to run. However, based on the stock market’s nosedive over the last two days and, more importantly, the flurry of recent data indicating a recession might be close at hand, forced this change. The most significant was this morning’s extraordinarily soft jobs number.  

For many months, this newsletter has been warning the labor market was not nearly as robust as the official data indicated. We may now be seeing a catch-up – or, in this case, catch-down – at work.  

In this regard, the closely-followed Sahm Indicator was triggered today. Basically, it measures the unemployment rate’s last three months’ moving average to the lowest reading of the past 12 months. When that gap hits at least ½%, the warning signal is activated. It has had a perfect track record going back to the early 1970s.

Because of the rushed nature of this switch out, our introduction will be shorter than normal. However, in our upcoming Making Hay Monday, we will analyze the current market environment with more detail.

It was only on July 19th we ran Kevin’s note warning that recession risks were greatly underestimated. In it, he boldly wrote, literally in bold font: “Get Ready For A Recession”. This was despite an overwhelming Wall Street consensus view that either a soft landing or no landing was a virtual lock.

Kevin also challenged the group-think on tech and particularly AI plays. As you know, they’ve been slammed in recent weeks.  

Here’s what we wrote at the end of our introduction to his July 19th missive:

Lately, we’ve been advising our readers to cash in some (not all) of their tech winnings. That looked like foolish advice until almost exactly the day Kevin published this note. Undoubtedly, millions of perma-bulls on tech are hoping, if not assuming, it’s another chance to buy the dip. Yet, after the stunning run stocks like Nvidia have had, it’s doubtful that this recent baby correction has flushed out enough of the speculative excesses. While a near-term bounce is entirely possible, be on guard for something much more painful for all those who have grown increasingly blind to a long and growing list of risks.

In Kevin’s latest piece, he delves into some of the acute risks that have been lingering out there in areas like the ultra-popular selling of volatility. That’s mostly done by institutional investors but the amateurs have been playing their own game of Russian Roulette by heavily utilizing Zero Days to Expiration Options. Both of these have the potential to turn a garden variety correction into something much more serious. Also, as we’ve frequently cautioned, a big rally by the yen, which has finally happened, could generate a disorderly unwind of the ubiquitous yen carry trade.

Team Haymaker is still hoping for a resumption of the Great Rotation that was well underway last month… until recession anxiety suddenly went viral. But we have to admit recessions are problematic for our preferred outcome of an Immaculate Correction.

The Haymaker Team

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WORRIED (Part 2 of 3)

How a correction brought on by a recession could be made much worse due to the 'tourist's five financial plumbing worries

Kevin Muir

(Excerpted by Team Haymaker)

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... since COVID, the risk of the economy slipping into recession had never been higher, yet the market was assigning less of a chance of this outcome than a year ago. The risk/reward for owning risk assets had become increasingly unattractive.

* * *

... developments that I wanted to highlight as possible areas of concern:

1. Momentum Strategies: everyone is chasing winners — whether that’s pod shops, indexing, or even the increased amount of retail participation.

2. Volatility Controlled Strategies: the sell-side has long used VAR (volatility at risk)* to monitor their inventory risk, but over the last decade, the popularity of vol-control strategies has created an immense pool of invested capital that is engaged in pro-cyclical trading.

3. Zero Days to Expiry Options (0DTEs): the popularity of this product is unprecedented and their volume has surged to the point where it is the most traded type of option.

4. Dispersion Strategies: although these trades have existed for decades, the last couple of years have been immensely profitable and have encouraged more risk capital to chase this strategy.

5. Government account volatility: the Treasury General Account or the Reverse Repo Program were non-factors a decade ago. Today, their volatility introduces risks that markets previously did not need to incorporate into their considerations.

*Haymaker note: We believe this should be Value-at-Risk

On their own, none of these concerns represent a reason to abandon risk assets. However, when combined with an overbought market and an economy potentially on the precipice of a recession, it suggests the potential for an ugly surprise is higher than usual.

* * *

Although value funds experienced a brief uptick in 2021, they have mostly shed assets over the past two decades.

US Value Fund Flows over the past two decades courtesy of BofA

Meanwhile, money has gushed into large cap funds.

US Large Cap Fund Flows over the past two decades courtesy of BofA

In the meantime, small-cap stocks have attracted practically nothing.

US Small-Cap Fund Flows over the past four years courtesy of BofA

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Eventually, this momentum-chasing behaviour will reach an extreme so great that investors will have difficulty ignoring the opportunities presented in other parts of the market. However, until then, the self-reinforcing feedback loop has only encouraged capital to concentrate into fewer and fewer stocks. There is no sense rehashing details about how top-heavy the stock market has become, instead I would just like to highlight this as an inherently unstable feedback loop.

Market Cap of largest 10 S&P 500 companies since 1980 courtesy of Goldman Sachs

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Even retail is contributing to this momentum chasing. The trend towards investors abandoning active portfolio managers and focusing on indexing has only accelerated. This creates a self-reinforcing feedback loop where the top-capitalized stocks receive the most capital — regardless of the relative investing merits of the position.

* * *

Momentum trading has always existed, but not to this extent. On the way up, this strategy seems to have little cost and is accepted as “the new way of the market.” But on the way down, it will bite with a fury that many market participants underestimate.

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Zero Days to Expiry Options (0DTEs)

Zero days to expiry options (0DTEs) have gained popularity is a shockingly quick time. Professors Bandi, Fusari and Reno outlined the explosion of the trading in these super-short-term options in their paper 0DTE Option Pricing.

* * *

All of this index option selling has the effect of dampening volatility, However, it also creates a self-reinforcing feedback loop that pushes volatility down, which encourages more option selling, which pushes volatility down even more, and so on…

* * *

I just worry that its success has pushed markets to levels where it will be difficult to continue wracking up positive performances and a rush out of the strategy could be destabilizing.

* * *

... even a decade ago, the Treasury General Account would only rise and fall $250 billion over the course of a couple of years.

US Treasury General Account (TGA) since 2000 (Haymaker note: The TGA is essentially the Treasury’s checking account.)

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... government account volatility seems to be especially acute during the transition from one government to another. The volatility of these accounts, and their corresponding (and often ill understood) effects, are risks that are underappreciated.

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... a regular stock market correction could end up being worse than forecast. Although many people have commented on the stock market’s inherent resiliency, I am not as confident that the system is as stable as it appears. My suspicion is that many of these factors are self-reinforcing feedback loops which have pushed stock market valuations to levels that are higher than otherwise would be the case. It likely won’t correct by returning to fair value.

* * *

If the recession gathers speed, then these other factors could make the market sell-off worse than expected.

* * *

Thanks for reading,
Kevin Muir
the MacroTourist

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