With only six more trading days in the month of October, this is why a stock market crash is coming. Plus a look at gold & Bitcoin and gold vs levitating assets.
By Bill Fleckenstein President Of Fleckenstein Capital
October 24 (King World News) – Given how uninteresting the markets have been lately, I’m going to start today a little differently and spend some time discussing one of the most important research papers I have read in a very long time entitled, “Volatility and the Alchemy of Risk,” written by Christopher Cole of Artemis Capital Management. I met Chris about seven or eight years ago at a Grant’s Conference and I was incredibly impressed by his knowledge of the incredibly complicated factors in options markets. He runs a fund that takes advantage of mispriced volatility and you can only do that if you are really talented…
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I have made the point many times over the last several years that I thought the structure of the market was such that it couldn’t really decline, it could only crash. In the last year or so I have been able to put some meat on the bones of that idea based on data from various people. After the recent Grant’s Conference, I shared the thoughts from one of the speakers who had tallied up the data to show that there are various strategies that mimic portfolio insurance and were sizable enough to create a similar outcome.
Cole’s paper goes into detail about that, and other factors, and I think that anyone who has any exposure to the market — either by having money in it or because you participate in our economy (which is to say, everyone) — needs to understand the points made in this report.
Just to share a few thoughts to wet your whistle, he notes that what we have been seeing lately has created a situation whereby, “Responsible investors are driven out of business by reckless actors. In effect, the entire market converges to what professional option traders call a ‘naked short straddle…a structure dangerously exposed to fragility.” He then adds, “Volatility is now the only undervalued asset class in the world.”
The Price for Business As Usual
Cole goes on to describe the “global short volatility trade” as, “any strategy that derives small incremental gains on the assumption of stability in exchange for substantial loss in the event of change.” One of the perverse reasons why a strategy as destined to fail as this is. continues is because it can work longer than one would think that it should, and then participants pile in thinking that the naysayers are delusional.
Cole adds, “Many investors, and even practitioners, are ignorant or in denial that they are holding a synthetic short option in their portfolio. In current markets, there is an estimated $1.12 to $1.42 trillion in implicit short volatility exposure…” He then describes what happens to folks who are in this boat where they all happen to be “short gamma.”
“When large numbers of market participants are short gamma, implicitly or explicitly, the effect can reinforce price direction into periods of high turbulence.” In other words, if the market starts down, everybody has to try sell at the same time, which is precisely what happened in 1987.
The Frequency Illusion
Cole then makes a side comment about algos and computerized trading that I thought was very important: “Markets are not a closed system. The rules change. As machines trade against machines, self-reflexivity risk is amplified. Ninety percent of the world’s data across history has been generated in the last two years. It is very hard to find quality financial data at actionable time increments going back past 20 or even 10 years. Now what if we give all the available data, most of it extremely recent, to a machine to manage money? The AI machine will optimize to what has worked over that short data set, namely a massively leveraged volatility trade. For this reason alone, expect at least one major massive machine learning fund with excellent historical returns to fail spectacularly when the volatility regime shifts…This will be a canary in the coal mine.”
There were many more great points that he made, which is why I say that everyone needs to read this. It explains not only why the market is crash-prone, but how this situation was created. And though we don’t know the timing, knowing what the outcome looks like helps one understand what they are up against so they can prepare a game plan.
Included below are three questions and answers from the Q&A’s with Bill Fleckenstein.
Betting On Gold
Question: Bill, after watching you, Mr. Skin and others discuss the lack of rational market action, I can’t help but wonder if it wouldn’t be more profitable to deal with what is rather than what should be. On 10/18 you said “When a rotting carcass of a company like IBM can see its share price do that on a mundane bit of news, it makes the point better than words can that, until something changes, making money betting against the lunacy is a costly endeavor.” Apparently the CBs will do what they can to prevent collapse. If AMZN, AAPL, TSLA or even IBM need to go up to make the indexes look good, the CBs can make it happen.
When the SNB bought billions of dollars worth of AAPL stock with money they created out of nothing, AAPL stockholders cheered, but the SNB got something for nothing. How is that not theft? The bears have been waiting for a setup or catalyst for years, but the market continues to melt up. Soros said “The object is to recognize the trend whose premise is false, ride that trend and step off before it is discredited.” If Soros is right, what is wrong with waiting for drops in market favorites, buying their calls and waiting for the CBs to ride to the rescue? Have you given any thought to trading tactics or financial judo that would enable us to take advantage of CB market manipulation?
Answer from Fleck: “If you can do it, and not get shaken out on pullbacks, AND get out before it tanks – then go for it. I do not wish to try because I know I’m not good at that sort of thing… I’m trying to take advantage of what they do via gold, but that trade has just been harder and trickier than it should be, or will be down the road.”
Bitcoin & Gold
Question: Just unbelievable to see Bitcoin soaring over 6k! And gold and silver going nowhere. And stocks up some almost every day. It’s sickening because it seems surreal. Are you at the point where even you are astounded?
Answer from Fleck: “Of course I am, but Bitcoin and gold have zero to do with each other, IMO. It’s more like a tech stock.”
Levitating Assets & Gold
Question: It’s truly stunning how poorly gold has performed given the levitation of all other asset classes. High yield bonds now yield (i.e., have a best possible return which likely will not be achieved due to defaults) 5% in the US and 2% in Europe. Stocks are priced at mid-single digit returns assuming we never have another economic downturn, are at all-time highs by a ton and seem to have 50% downside. Investment grade bonds, well, have zero real yield (essentially cash). Real estate in the U.S. is back to 2006 peak levels. Even the crypto-currencies have multiplied their value over the past several years. Gold seems to be the only asset class in existence that consistently gone down. This seems unprecedented in history, but has now been the case for a few years and just marches on. Am I missing something or was there another time that it acted like this? Even in 2000 the non-Nasdaq stocks never got crazy. Is gold now just an S&P / crypto-currency put option at this point? I’m starting to wonder if it has lost it’s status as an “asset class”, which makes me wonder what makes it ever work…
Answer from Fleck: “Given the levitation of all other asset classes” that is why gold has been laboring… I’m surprised you think levitating asset prices (because everything will work out so well) should make gold go up faster? Gold is up 12%, SPOOS are up 15%, why are you so upset? Cryptos are an asset class, they are just a concept like silly dot.com stories.
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