“Like all of life’s rich emotional experiences, the full flavor of losing important money cannot be conveyed by literature.”
–Fred Schwed in “Where are the Customers’ Yachts?”
Recency bias is pretty straightforward… we tend to use our recent experience as the baseline for what will happen in the future. In going through the paces on scenario analysis, we assign larger probability weightings to events that have happened in the recent past.
The financial world is obviously littered with instances of recency bias. Whether it’s assumed raw material prices for modeling project economics, volatility assumptions for pricing derivatives and structured products, or pension fund allocation decisions, this behavioral overhang is here to stay.
I’m curious to see how the next big correction takes shape. Many in active management are under fire for underperformance, “undeserved” fees, and overall lack of evolution (for some). In short, the game today seems to be an arms race for automation and big data. How much information can we take in, filter and contextualize within our framework in the shortest amount of time? One thing I feel confident saying is that a true informational edge is increasingly harder to come by.
Companies like Betterment, Wealthfront, and other automated low-fee alternatives have taken in billions in assets (in many ways, the concept is a good development in principle). Like myself, many young investors have never experienced a major market correction, and neither have many seasoned investors in a long time. I personally remain skeptical that low-fee automated alternatives address the elephant in the room…
A report by ZenithOptimedia estimates the average person will spend ~500 minutes of their day consuming some kind of media in 2017. Wealthfront claims to “do all the work so that you can focus on the things that really matter to you”. So you’re telling me that when the market is already down 20% and the young millennial is being blasted with real-time commentary about how the world is ending from three different devices, technological advancement and automation will prevent them from making the wealth destroying decision of selling? I don’t buy it. We’ll see.
Back to the Global Macro Grind…
We spend a good amount of time internally trying to get a handle on positioning, sentiment, and investor psychology in global macro markets. It’s not an exact science. We take-in information with a multi-factor, multi-duration quantitative tilt while also remaining weary of falling into the hard rules and theory trap (“if we get to a level on x, we do y”).
With perceived underdogs winning out with Brexit and U.S. elections, these two recent events are creating some investor angst into French elections, to say the least. We highlighted this political set-up yesterday, so here’s some additional market driven context…
Investors hedging exposure to BREXIT last June were paying prices that were arguably nowhere near as divergent from trending conditions compared to hedging prices paid in front of the French elections currently. In our process the quantitatively-driven assessment of what has and is actually trending is more important than opinions and elusive geopolitical catalysts (these things do matter to us).
- The day before the Brexit vote, you had to pay up +50% and +33% above recent market trends (realized volatility) (30D and 60D window) in the CAC 40 for at-the-money puts. In the other major European indices, it was nearly the exact same set-up.
Brexit was a real surprise. The event happened, and realized volatility quickly reflected the surprise after the fact. If you look at markets used for hedging however, peak fear was priced in coincidentally with BREXIT, before getting cut in half over the next two months. Today in Europe, volatility hasn’t actually picked up. It’s been crushed to near all-time lows as the expectation of future volatility has skyrocketed, jacking implied volatility premiums to all-time highs in the case of the CAC 40.
- At-the-Money put implied volatility in the CAC 40 is +64% M/M which is the largest divergence in global macro behind the Euro currency. The FTSE MIB, DAX, and EuroStoxx 50 all screen in the top 10 largest divergences, while;
- Some of those same indices have seen the largest declines in realized volatility M/M. 30D realized volatility in the CAC 40 is -37% M/M and is trending in the 1st percentile of historical readings, with the index +1.5% M/M.
- Skew in the major European equity indices as a region and asset class is by far the most extended in macro using a standard deviation methodology. This time series compares put implied volatility on a 90% strike to call implied volatility on a 110% strike (See Chart of the Day).
So the price of insurance as seen through a large swath of high frequency data, has been steadily increasing over the last two months as these indices have grinded higher on tighter trading ranges. The current set-up has been pervasive in European equities long before the more recent pullback. So although an argument can be made that the large divergence in expectations over trending conditions is due to a low volatility environment (we all know that vol is likely to go higher and not lower with time), the outcome will need to be pretty eventful in our view to justify expectations baked into prices. As mentioned, implied volatility peaked in conjunction with the BREXIT event, with the hedges being unwound pretty quickly despite the big surprise.
To wrap it up, the main goal on our studying of futures and derivatives pricing is to 1) Get a sense as to what magnitude consensus has front-run coming events and catalysts, And; 2) To identify opportunities when consensus is betting against our views and/or the market’s general trend.
We get questions and pushback on our conclusions of this data frequently… “The contract positioning is extended because people use that market to hedge.” Our answer or question back takes shape as follows:
- Well then why weren’t they hedged 1 month, 2 months, 3 months ago?
- Hedging and unwinding of hedges moves derivatives prices independent of the move in the price of the underlying which presents opportunity. In other words, at the extremes, coming catalysts will always be created, which will move derivatives prices even if the underlying trend doesn’t budge.
A large percentage of macro participants are paid to make noise, and coming catalysts and risks are created and recycled from that noise. The French elections may turn out to be a major volatility event that ends in the demise of the Euro-experiment. I don’t have any edge, but I think recent precedents have juiced the perceived risk associated with the event.
In a world that is increasingly blasted by information, the noise is louder than ever. You can automate everything about data gathering and processing, but as long as there is a human plugged into the noise behind the machine, we will allocate time and effort to understanding his or her positions.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.23-2.42% (bullish)
SPX 2 (bullish)
RUT 1 (bullish)
NASDAQ 5 (bullish)
Nikkei 188 (bullish)
DAX 12092-12330 (bullish)
VIX 10.91-15.97 (bearish)
USD 99.75-101.34 (bullish)
EUR/USD 1.05-1.07 (bearish)
YEN 109.16-112.50 (bearish)
GBP/USD 1.23-1.26 (bullish)
Oil (WTI) 49.43-54.01 (bullish)
Nat Gas 3.09-3.36 (bullish)
Gold 1 (neutral)
Copper 2.52-2.63 (bearish)
Good luck out there,
Ben Ryan
Macro Team
