“In other words, they lost their shirts. But they did not care.”

-Benoit Mandelbrot

Since I did it all day meeting with Institutional Investors in New York City yesterday, this morning I want to spend a little time openly debating myself on the sentiment signals embedded in implied volatility premiums and discounts.

If we want a base-pack for that debate, we have to go right to The Brot who, in The (mis)Behavior of Markets, best recounts the history of how Fisher Black and Myron Scholes came up with their options formula:

“They also tried it out, literally. They started with warrants and noticed several in the market that, according to their formula, looked cheap…” (pg 74). And “cheap” got cheaper… they lost their shirt, then went on to try to get published anyway.

Implied Consensus - Bull and bear extra cartoon

Back to the Global Macro Grind

When I’m in client meetings, I can’t say I get in drop-the-gloves, jersey over the head, fights about “valuation.” But I definitely get some looks from people like they want to go when I say something like “valuation isn’t a catalyst.”

You see, I’m a macro guy… and whether people want to empathize with that or not doesn’t concern me. I sincerely want them to understand that “expensive” macro exposures tend to get more expensive (and “cheap” gets cheaper) if the prevailing winds in growth and inflation (trending direction in their respective rates of change) remain pervasive.

From a bottom-up stock picking perspective, valuation might provide a fantastic buying opportunity when something is “cheap.” But something needs to change to make it less cheap. After all, it got cheaper (or stayed cheap) for a reason. And with individual equity and fixed income securities, you can always look for a bottom-up company catalyst for that.

With National General (where the aforementioned shirts were lost), Black & Scholes bought the wrong “cheap” security with no catalysts!

In the last 2 days, what was the catalyst for the Nasdaq (5531 close yesterday) to register back to back all-time closing highs? Was it a bird? A plane?

A) No

B) It was a performance chase for macro exposures that not everyone has

C) High Beta Growth Stocks are a great way to express US Growth and Inflation #Accelerating (Quad2)

The other thing that’s made buying both the SP500 and Nasdaq on pullbacks for the last 6-8 weeks a profitable venture is sentiment. Whether people admit it to you or not, positioning hasn’t nearly been bullish enough on QQQ or SPY.

The Old Wall way of hosting a dinner where everyone writes down their “SP500 target” or “bullish/bearish” view of the market might seem fun to people, but I don’t think it’s very helpful. Why not use the right sample size, and look at things like:

A) Aggregate positioning from a net long/short perspective in futures and options markets?

B) And/or implied volatility premiums and discounts (implied volatility vs. realized volatility)?

I can’t tell you these modern behavioral read-throughs are perfect. Nothing is in gaming the game of what sentiment really is… but I can assure you that this is where both we and our clients are doing a ton of research.

If you have the answers and/or thoughts to these questions, we’d love your feedback:

  1. Do you consider rising implied volatility premiums a bullish or bearish indicator?
  2. Do you consider falling implied volatility premiums a bullish or bearish indicator?
  3. And when you flip to implied volatility discounts, do you think rates of change matter as well?

I know I tend to be a little shy on telling people what I think, but here are my answers:

  1. I think rising implied volatility premiums are encouraging me to believe that being bullish is not consensus
  2. I think falling implied volatility premiums mean I’m getting paid on the long side and should book some gains
  3. I think that when implied volatility falls and trades at a relative discount, I have no business calling my longs contrarian

Every time we’ve said “buy the Nasdaq” (going back to late November’s pullback), what happened was implied volatility premiums were rising. That meant consensus was expecting more volatility (after the move), not less.

Today, after the big move (the Nasdaq is +9.6% and +5.3% from its November and December 2016 lows, respectively):

  1. 30-day realized volatility has been crushed to = 11.5% (vs. 16.6% 90-day)
  2. At the money implied volatility has come all the way down to 13.0%
  3. 30-day implied volatility premium has come down to +9.1% vs. a 3 month avg premium of +15.3%

I’d much rather buy the Nasdaq when implied volatility premiums (on 30-60 day durations) are running +15-30% than here. That’s what makes the SP500 a more interesting “BUY” now on pullbacks. Its 30 and 60 day implied volatility premiums are +16-24%.

As always, we care about your risk management process when timing your portfolio decisions. We don’t want you to be chasing consensus’ tail and lose your shirt. There’s an implied consensus we can all learn from – it’s all in the last price.

Our immediate-term Global Macro Risk Ranges (TREND views in brackets) are now:

UST 10yr Yield 2.33-2.58% (bullish)

SPX 2 (bullish)

NASDAQ 5 (bullish)

XOP 40.08-42.80 (bullish)

VIX 10.61-14.27 (bearish)
USD 101.25-103.75 (bullish)
EUR/USD 1.03-1.06 (bearish)
Oil (WTI) 51.68-54.80 (bullish)

Best of luck out there today,

KM

Keith R. McCullough
Chief Executive Officer

Implied Consensus - 01.10.17 El Chart