Short Term Uncertainty

As we run into Thanksgiving, traditionally the ‘end of the year’ for a lot of trading funds, many market signals are being distorted; by options trading and gamma squeezes in equities and by forced unwinding of curve trades in the bond markets. Sentiment meanwhile is running hot in the momentum parts of the market which once more is concentrated among mega caps, and may be offering some opportunity in the value v growth switch, especially as the commodity markets are starting to show renewed signs of upward pressure. Gold and the DXY dollar index are finally breaking to the upside which suggests that some profits may already be being ‘booked’ elsewhere. Thus with short dated options trading in momentum stocks causing what appears to be ‘irrational exuberance (to resurrect that old phrase), it may be that the best option is to rotate towards some of the less loved value stocks.

Sentiment in positive almost everywhere except bonds. Equities, commodities, Crypto and even Gold seems to be breaking out of its range to the upside. All of this may help explain the fact that the US$ appears to have also finally broken to the upside. As the AAII Individual Investor Bull versus Bear chart illustrates, while bullishness had been on a downtrend since April, after the brief sell-off in September, investors are now almost as bullish as this time last year, even though the S&P is up over 30% over the period. Indeed, up until the end of this last week, the S&P500 has made new highs for 16 consecutive days! The Bull/Bear index is widely believed to be a contra-indicator, but we don’t necessarily agree, practical experience has seen this higher and the stock index has continued to rise. Rather, we see it as not only a good coincident measure of sentiment in what is probably best referred to as a meltup, but also it is often a helpful signal of some rotation between momentum and value, especially when, as now, it coincides with positive signals from (most) commodities and a notable upturn in measures like the Citi Economic surprise Index.

AAII Individual Investors back to Bullish.

There is definitely an element of seasonality going on here and it is worth considering that the traditional ‘Santa Claus rally’ often occurs after a moderate post-Thanksgiving (the real year end for many traders) correction or selloff. In effect a lot of the December activity is pre-positioning for the year ahead. Importantly this year there has also been as a sharp rise in the use of short term call options that is helping to exaggerate movements and, if anything, it is this options activity that presents the biggest near term risk to markets as they expire.

We know that the VIX has also now spiked higher and is near the sort of levels we last saw running into the September triple-witching that triggered the last market mini-correction. However, rather than the conventional view of the VIX as the so called ‘fear index’, we find it more helpful to see it as an expression of the price of Put options. Thus we can see that one of the reasons that implied Volatility was so low in late October was that people had been selling puts and using the premium to buy calls, not so much using options to hedge underlying positions, but by essentially doubling the same bet. With leverage. As such, they were building instability into the system and this is where we believe much of the short term risk lies at the moment.

In particular, we know for example that there was enormous short term call buying in Tesla over the last few weeks, helping the underlying share price go parabolic and, as that particular technicality unwinds, it is also putting a drag on the equity markets overall given the size of the potential moves and the size of the market cap.. The Chart shows the dramatic spike and reversal in the Tesla short term 1200 calls in the last two weeks by way of example. Hope you didn’t sell the puts to buy those calls?

Tesla – trading like a Crypto with an electric car company attached.

It may well have been that holders of the underlying may have been trying to ‘goose’ returns in the underlying holdings of the stock ahead of an approaching year end and a big performance fee. Readers may recall that this sort of ‘Texas Hedge’ (owning the underlying and trying to manipulate the options market makers to squeeze it higher) was allegedly what the ex DB traders at SoftBank were doing this time last year. Then they were (again allegedly) trying to trade their way out of the problems they had with WireCard and Won’tWork, while this year they have been relatively quiet, apart from THG group of course. Oh and the $50bn hit they took on their Chinese internet stocks in the early autumn. So maybe they are back with a re-run of the Nasdaq Whale? Or maybe someone else is? The run up to Thanksgiving and the closing of year end books (and booking of performance fees) is often a time when we see some hedgies ‘putting it all on red’ and a Texas Hedge designed to run a gamma squeeze is not unheard of shall we say. Well, they have two weeks left.

Valuations however are not so stretched, as the earnings have come through in excess of expectation, but there has definitely been some distortion from the Tesla effect – when one of the largest stocks in the index moves up so sharply it dominates ‘contribution to return’ and causes a lot of problems for active investors not in the stock. After all, if Tesla has given back 50% of that late October spike, then the impact it had on the index (approximately one third of the late October rally in the Nasdaq was down to Tesla on its own) will also unwind. As an aside, there is an even bigger distortion in the venerable Dow Transportation Index – used in conjunction with the Dow Industrials Index for the Dow Theory of market signals. One company, Avis, has spiked dramatically over the last two months such that on its own, it has driven over 50% of the move in the Dow Transportation Index.

All this is somewhat reminiscent of late 1999 when Vodafone was almost 15% of the FTSE index and was similarly distorting in its behaviour. The following chart from our good friends at Redburn highlights the surge in this concentration effect is now greater than it was even back then. Indeed, we are basically back to the days of the nifty fifty – or is it now the nifty five? It also makes a mockery of the concept of diversification when the ‘tail’ of otherwise major companies is so long. The weight for Microsoft in the SPY ETF that tracks the S&P500 for example is 10x that of Cisco, and Cisco is still number 25 in terms of size! Of course some may remember that when Vodafone was the biggest stock in the UK market, Cisco was equally once the largest company in the S&P500, before it subsequently dropped by 50% over the next 18 months.

Of course, Vodafone peaked in March 2000 and since then has lost approximately 80% of its value such that it is now only 1.6% of the FTSE. The big question is therefore, could Tesla go the same way as Vodafone? Of course it can, but as we noted in our discussions on Rivian last week, currently Tesla is basically a Crypto ‘coin’ with an electric car company attached and if we are talking about diversification, there is one person above all others who should be selling. There is an expression about feeding the birds when they are chirping and it looks like Elon Musk is doing more than simply selling stock ‘to pay taxes’ – as opposed to just exercising and then selling a long dated call option that was expiring next August. Meanwhile, we would note the clever way in which Elon Musk ‘framed’ the decision to sell stock by issuing a Twitter poll and making it about taxes. When you sit on top of a meme stock, communication with investors is probably the most important part of your daily strategy (certainly it seems better planned than the car division). The fact that he did it this way rather than discretely through his bankers suggests he may indeed be divesting rather more in future.

To play around with numbers for a moment, at its peak, Cisco traded on around 25x sales, while Vodafone was on around 28x. Tesla is currently on around 22x current sales. To stick with Vodafone for a moment, because, like the discussion now is around Tesla, Vodafone transitioned from a hot tech company to more of a utility. If, for a moment, we assume that the market had perfect foresight of Vodafone’s future sales (which peaked in 2003, then, at the market peak it was on 7.5x future peak sales. Tesla, by contrast is on 9x 2025 sales estimates, which are already more than double this year’s numbers. The issue here therefore is , that by the time Vodafone achieved those peak sales, the market was discounting the new version of Vodafone and only willing to pay 2.4x future sales. Were we, again for fun, to apply the same logic to the post 2025 Tesla – with its more utility like nature as a power company, then 2.4x those 2025 sales would mean a share price around 75% lower. It sounds absurd, but then that is only where is was in July 2020!

Meanwhile the unwind of the Bond market yield curve trades is also sending confusing signals to anyone who still believes that the Bond market is telling us anything about the economy. The MOVE index of Bond market volatility remains high, which, with the move up in VIX as well may cause further trouble for the risk-parity funds (who tend to be forced sellers of the underlying when volatility rises).

The ‘eye-popping’ inflation number (to quote the Fed’s Mary Daly) might not have been exactly unexpected, but psychologically it is very significant. At 6.2%, it is the highest level for 30 years and even though the Fed continue to insist that this is temporary, bond markets continue to sell off. However, at the same time, the yield curve is flattening as long bonds fare less badly than short dated bonds, which at first glance looks counterintuitive, after all isn’t the short end supposed to protect you (relatively) from inflation? In reality of course what we are seeing is the consensus ‘steepening’ trades unwinding. In effect, the macro traders had already been betting on high inflation by going short the long end and long the short end, expecting the Fed to keep pinning the front end of the curve down while inflation made the long end sell off. They were right about the inflation, but missed the second order effect that the Fed might stop buying the front end (as the Canadians and Australians have) which has led to a scramble to unwind the ‘steepeners’, causing forced buyers of the short positions at the long end and distressed selling of the long positions at the short end. Or, as Bernard and Sir Humphrey might have said to Jim Hacker had he asked them to explain what was happening in the Bond Markets;

In the end, if too many of you are short the Long End and long the Short End, and you are therefore long short and short long for too long, then you can all end up getting caught short…

Medium Term Risk

The fast approaching year end should be making Asset Allocators think about some strategic rebalancing over and above that automatically generated by benchmarks and volatility. While observing the knots that the short term leveraged traders have tied themselves up in with their yield curve strategies, the psychological impact of US inflation at the highest level for 30 years will undoubtedly raise some questions about owning bonds as an asset class. As noted in the past, we have long been in an upside down world where bonds are held for capital gain and equities for income – even if that isn’t acknowledged by many asset allocators. As noted above, the AAII sentiment indicators are currently strong and are (likely) mainly focused on the momentum stocks, but with the Commodities markets and many early economic activity indicators pointing north once more (in spite of attempts to portray China as in imminent danger of economic collapse) a rotation back towards cyclical/value may once again be in order. The fact that many of them have decent yields should help their cause as a home for income seeking capital now looking at capital loss and no yield to mention in bonds.

This is certainly helping financials, but should also help industrial materials and other cyclicals. In particular, the old notion in commodity markets that higher prices bring forth higher supplies is being at least temporarily distorted by governments and the green agenda, most obviously in the energy space. This is partially due to supply chain issues and poor planning in the area of winter natural gas in Europe and gasoline in the US, but that should not obscure the quixotic approach to medium term investment in energy transition and we can’t help feeling that as the political landscape hots up in the next 12 months (and the globe does not) that some of this will be rowed back due to expediency and also as the Green cause begins to be undermined in terms of popularity as it is seen to cause ‘Green Inflation’. Already, we notice that Joe Biden is asking for the Saudis to pump more oil and is once again selling them weapons (despite campaign claims he would do the opposite). Meanwhile, we also note that the Baker Hughes rig count is steadily grinding higher as Oil services start to respond to shortages and higher prices.

In fact, and as we noted amid the hubbub of the recent convocation of Billionaire Cardinals at ESG Glastonbury, the western governments have already revealed their medium term plans for meeting base load power and the transition to electrification, New Nuclear. Thus, while it is interesting to note that the price of INRG, the I-shares Global Clean Energy ETF is stabilising and recovering once more (it was a major component of our Thematic basket Model Portfolio last year, but we have had very low to zero weight for much of this year), probably suggesting that the ESG funds are chasing the usual names once more, what remains astonishing to us at least is that the very sectors requiring long term capital investment to meet these challenges – nuclear power and Uranium and Copper mining – are explicitly banned by the UN and the ESG funds!

The fact that the consultants advising Institutional Investors confirm that no ESG mandate allows for investment in Nuclear Power, Uranium or Copper mining – the very components of the agreed ‘solution’ to Climate change – is as startling as it is ridiculous.

Given the fact that the US Infrastructure Bill, the continued growth of China and the realistic responses to energy transition all require basic materials, it makes sense that fading the ESG driven selling in these areas (which may indeed be over in any event) may be more rewarding than chasing the usual ‘green’ names – although that may well still be a strategy. It all depends on who is actually setting the opportunity set.