Fragile Markets

This note was originally published December 12, 2013 at 07:45 in Morning Newsletter

“I’d rather be dumb and antifragile than extremely smart and fragile” Nassim Taleb

The big picture

The hyperbole of that quote is that Taleb thinks he’s extremely smart. I’m definitely dumber than he is. So I guess he’d agree that I should never hire him to do what I can do better myself – manage real-time market risk.

 

It’s a great job for a dumb hockey player.

Macro grind

The reason why I thought of Taleb this morning is that I was thinking about volatility. To his credit, he was one of the first to write about risk managing volatility from a market practitioner’s perspective. That doesn’t mean I agree with everything he wrote.

 

In terms of how we measure market entropy in real-time (multi-factor, multi-duration), yesterday was a one of the few critically bearish signal days for the US stock market.

 

To boil that down to 3 basic factors in our model (Price, Volume, and Volatility):

 

1. PRICE – SP500 A) failed to make a higher-high versus the 1808 all-time closing high and B) broke 1785 TRADE support

2. VOLUME – was +13% versus my immediate-term TRADE duration average (1st mini-volume spike on a down price move)

3. VOLATILITY – front-month VIX broke out above @Hedgeye intermediate-term TREND resistance of 14.91

 

This has never happened before (because the SP500 has never been at this all-time closing high before). But historically, countries, currencies, companies (anything with a ticker) do this frequently. And when they do, I respect Mr. Macro Market’s signal.

 

What is a bearish immediate-term signal @Hedgeye?

 

1. PRICE = down

2. VOLUME = up

3. VOLATILITY = up

 

Conversely,

 

1. PRICE = up

2. VOLUME = up

3. VOLATILITY = down

 

… is a bullish immediate-term signal @Hedgeye (especially when it’s happening within a bullish intermediate-term TREND).

 

Sure, I have been buying-the-damn-bubble #BTDB pretty much all year – but while I covered a couple of oversold shorts like CAT yesterday, I didn’t buyem on the long side. An intermediate-term TREND breakout in volatility is the #1 reason for that.

 

Are there tangible risk factors that could perpetuate and intermediate-term TREND move in US Equity Volatility back towards 20 on the VIX? Big time. Here are some behavioral ones that I discussed with clients in NYC yesterday:

 

1. VIX has been making a series of higher-lows since AUG as the Fed started to confuse with Taper-on/Taper-off in SEP

2. The average “net long” positioning of the hedge fund community is testing its all-time high zone of +60% again

3. The II Bull/Bear Spread just blew out to fresh 5 year highs of +4390 basis points to the BULL side

 

That last point is one of the more fascinating migrations I have seen in my career. To put a 44% spread between bulls and bears in context, that II Bull/Bear Spread was only +1710 basis points wide in the 1st week of September 2013.

 

Early September – that’s when people may have claimed to be “bullish” but they certainly weren’t positioned Bullish Enough. All this market needed to scare the hell out of the pretend bulls was a VIX rip to 17 in late August.

 

If the VIX goes to 17-18 tomorrow, people who are buying-the-damn-bubble #BTDB will get killed. So, if you have been in the habit of doing the buy on red, sell on green #GetActive thing, you want to be more careful buying now than you were last week.

 

How about fundamental research factors that could turn bearish in the next 1-3 months?

 

1. US Dollar being devalued and debauched (no-taper) towards its YTD lows

2. US GDP #GrowthSlowing from its cycle high of +3.6%

3. Down Dollar = Up Yen = Down Nikkei (another thing people didn’t enjoy in late AUG)

 

Rather than making up my own academic sounding word like antifragile, I’ll call managing real-time market risk this way what it is – being mentally flexible. If you can Embrace Uncertainty every market day, you might feel less dumb every once in a while too.

  • CASH: 58
  • US EQUITIES: 6
  • INTL EQUITIES: 6
  • COMMODITIES: 0
  • FIXED INCOME: 8
  • INTL CURRENCIES: 22

Our levels

Our immediate-term Global Macro Risk Ranges are now:

 

UST 10yr yield 2.76-2.91%

SPX 1779-1815

VIX 14.31-15.67

USD 79.67-80.38

Pound 1.62-1.64

Gold 1216-1260

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

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