Wall Street Sells Low & Buys High... Wait... What?

Wall Street Sells Low & Buys High... Wait... What? - fetal position

 

The pressure to beat one's benchmark often causes Wall Street to violate some very basic investing principles. It happens, especially to investors without a risk management process to contextualize big picture macro moves.

 

Call it short-termism or momentum chasing, whatever you call it, even big institutional investors, the "smart money," fall prey to buying stocks at all-time highs then panicking and selling as stocks correct. That's basically what has happened in the past two weeks. This type of manic trading can cause some serious performance issues.

 

Last week, S&P Dow Jones Indices released their latest SPIVA report card, showing how active managers performed versus the broad stock market benchmarks. Here's the headline finding:

 

"Over the 15-year period ending Dec. 2016, 92.15% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective benchmarks."

 

So in excess of 90% of active managers across investing styles failed to beat their benchmark. Not good.

Wall Street's Performance Chasing

Now consider last week as a case study in performance chasing. As Hedgeye CEO Keith McCullough wrote in this morning's Early Look, "After last week’s US stock market corrections, the options market priced in an implied volatility premium (vs. 30-day realized volatility) of +103% for the Nasdaq." This is technical stuff but basically investors, fearing the worst was yet to come, piled into downside protection after stocks fell.

 

(A brief reminder: Implied volatility is investors' expectations for the volatility of an asset in the future. Realized volatility is the actual historical volatility of an asset over a set period of time. An implied volatility premium, in which the implied volatility is in excess of realized, essentially suggests fearful investors are expecting future volatility above what's already happened in the past. A discount conversely suggests investors have a sanguine outlook.)

 

Then, yesterday was the biggest up day for the stock market in a month and a half. What happened? As stocks headed higher, formerly fearful investors were forced to sell off that downside protection and buy stocks (i.e. chase the move). As you can see in the Chart of the Day below, implied volatility premiums pulled back to 98% for the Nasdaq.

 

Wall Street Sells Low & Buys High... Wait... What? - 04.18.17 EL Chart

Understanding Volatility: What's It all Mean?

Implied volatility premiums or discounts are just one of the factors we use to interpret where markets are headed next. It's actually a great read on sentiment. If an asset class gets too stretched in either fear (i.e. implied volatility premiums) or complacency (i.e. implied volatility discounts) we take a look at that asset class more closely. 

 

The next question is, does this asset class screen well from a fundamental research perspective? On the Nasdaq specifically, we've been writing a lot on that recently, which is why we wrote "buy last week's stock market dip."


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