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What We're Reading This Week

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May 03, 2018

What We're Reading This Week

Author: Thad Schlaud

Topics: News, The Market, Industry Ideas

The Market

I don’t normally write about the stock market in general, but 2018 market action following a year like 2017 seemed like it was worth writing about. Why should we feel so terrible about a flat market in the first four months of the year? Why should normal market conditions feel like something more troubling?

Ultimately, I think it’s because we were spoiled in 2017. Barry Ritholtz at Bloomberg points out some of the anomalies we saw in 2017:

  • Above-average U.S. market returns;
  • Record corporate profits;
  • Even higher returns overseas, especially for U.S. investors when priced in dollars;
  • Record-low market volatility;
  • Record-high political volatility;
  • Fed funds rates near record lows;
  • Market interest rates near record lows;
  • Below-normal inflation; and
  • Low bond yields.

When you take that into account with an unwinding of the short volatility trade, it’s easy to see how pent up market volatility could explode into the landscape. The initial drop in January triggered additional selling, as well as the ultimate closure of Credit Suisse’s short-vix fund, which triggered more selling. As things return to normal, people start to look for meaning where there isn’t any.

To understand this concept, you have to look at two aspects of human behavior: confirmation bias and apophenia.

We’ll start with apophenia, the phenomenon whereby people assign meaning and significance to unrelated and random events. The first place people look for market guidance is the economy and Washington, D.C. Most investors give both significantly more credit than they are due. Next, confirmation bias kicks in. When people want something to be true, they search out and pay attention to evidence that supports the belief they already have. When the market is good (2017) presidential supporters talk about the Trump Bump. When it’s bad (the past few months) detractors talk about the Trump Slump.

When viewed through that lens, it takes an overly simplistic view of the factors moving the market. It’s also completely focused on the past. It’s easy to look at market activity and make deductions about the past based on already held beliefs about unrelated events.

Finally, we have to consider negativity bias. This is our natural instinct to overweigh negative experiences and ignore positive ones. We are hard-wired to avoid risk; it’s a survival instinct.

The market doesn’t mix well with our personal biases. Right now, investors are looking for meaning where there isn’t any. They are forced to question what they believe and ultimately, end up believing that things are much worse than they are. Knowing these things doesn’t stop people from feeling this way, but hopefully it stops them from making a stupid decision.

More on the Market

Case in point, Wall Street stock traders are finally having their day in the sun. All of the volatility this year has driven people to trade! Not just in equity positions but also in derivatives, like the VIX, but mostly options and futures.

“Overall, U.S. options trading enjoyed its busiest quarter in history, by one measure, according to research from consulting firm Tabb Group and data provider Hanweck. Nearly 1.4 billion options contracts were cleared in the first quarter, up 33% from a year ago, the firms said.”

With increased price movement, fund managers and institutional traders are looking to mitigate their risk. When you buy a stock, one way to reduce your losses is to hedge the investment with an option, known as a put, or a call. When you are hedging a purchase, you would buy a put. Stated simply, it’s a contract to sell a stock at a specific price. If I buy Apple stock for $165/share but I’m worried it will go below $150/share I can buy a put at the $150 price point that allows me to sell at that price even if the stock drops well below that mark. Someone that thinks Apple will not go below that point would sell me that contract. Most contracts expire worthless. Meaning, they are never executed. In that regard, they are like life insurance policies. You buy them to reduce risk and hope you never use them. These types of trades have a cost, but typically that cost is justified considering the potential loss if the “insurance policy” is needed. That being said, if the hedge is not executed, these trades are simply another expense on the balance sheet.

Large banks collect those expenses as these types of trades are usually employed by large, institutional wealth managers – clients of those banks. Most retail investors (you and me) do not engage in sophisticated hedges with our portfolios.

A simpler, and more effective approach is to exit the market in the face of that volatility (like Gainplan). This option is not available to large institutions because of the size of the portfolio. Making buys and sells with that much money can actually cause the market to move on its own.

 

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