“I call it REALLY private equity”
– Rick Ruback
Rick Ruback and Royce Yudkoff are professors at HBS who wrote a book about small scale business acquisition. I pulled the coined term above from a recent interview with the duo when the topic of “acquisition multiples” surfaced. Namely the barriers and opacity in the space keeps multiples much lower - they recommend looking where less institutional money is willing to go for various reasons. If you’re interested in the topic, both the book and INTERVIEW were well worth the time in my opinion.
To each his own, but any financial market described with the words “opaque”, “boring” and “less-traveled” is exactly where I want to be...
We had an internal discussion at Hedgeye this week about continuing to evolve on the data front from a gathering and processing perspective. I’ll leave it at that, but I think consensus was in agreement that having an informational “edge” in heavily-traveled public markets will not be getting any easier from here. We commend our buyside clients for fighting that fight every day. So from here we can 1) embrace evolution or 2) find that “less-traveled” path. Both could be great options.
Back to the Global Macro Grind…
In our push to evolve, one point of process that we have externalized in the last 6-9 months is our use of derivatives to express or hedge our views. I consider it analogous to having more shots in your golf bag. You may be perfectly capable of hitting a great shot into the green with your normal ball flight, but then there’s wind, elevation, and hazards to deal with much of the time. Your game might get just a little more versatile if you can hit that shot a little better based on the givens – at least that’s our take. Golfers call this putting “more shots in the bag”.
In an attempt to simplify the complex, we’ll give you two conclusions about volatility expectations and thus option pricing drivers which are both logical and data-driven:
- Implied volatility front-runs perceived event-risk due to hedging or expressing outright views
- As a market trend persists (backward-looking), implied vol takes shape around that trend persisting into the future
On point #2, a big surprise or re-pricing typically occurs at the extremes, and it happens more sharply from a price perspective which presents opportunity within our framework. Just Monday, we flagged all U.S. equity-related volatility indices which were trading in low single-digit percentiles (5yr window). Not to mention the “term structure” of volatility was literally at all-time lows in many U.S. equity-related tickers just last week. I’m talking IWO, QQQs, NDX, XLY, SPY. “Term structure” measures implied volatility at different contract expiry dates. Eventually when the market expects an unprecedented volatility environment to last far into the future it should be flagged at the very least.
As Keith wrote in last Thursday’s Early Look, “I’ve raised my ‘cash’ position right back to the highest level I’ve had it in the last 6 months.” The good news is we write everyday so people can fact check the good and the bad.
After a day like Wednesday, we recalibrate our levels, go back to the wood on our data-driven fundamental views for the rest of 2017, then ask ourselves if we have any edge on Trump’s pending “impeachment”…we don’t over what we see on our screens.
We discussed our views in real-time Thursday morning in a note to clients:
“U.S. Index Skew – Proof of the Scramble – Good look at how investors [man and machine] go right to the deep and liquid S&P or index ETF options markets to hedge during a sizable down-day. Many of those investors probably don’t frequent these markets unless they’re forced to go buy protection, and if it’s a small hedge relative to their position, they’ll pay whatever they need to…
If we wanted to be long of anything U.S. equity related today, selling vol with put spreads is a way to play yesterday’s move (selling a put close to the money and buying one farther down to cap downside loss)
The visual below looks at skew. The table [also today’s Chart of the Day] compares put implied vol on the downside 80% and 90% strikes vs. put implied vol at the spot price (100% strike). Very quickly the S&P 500 (SPY and SPX) reprices among the most skewed volatility surfaces in macro along with technology (XLK).”
Skew ultimately compares the price of downside put volatility to spot price put volatility or upside call volatility. You probably guessed it, but the surfaces of SPY and Tech were not relatively skewed last week, and 9 out of the top 10 volatility surfaces with the lowest term structures in macro last week - all US equity-related - are nowhere near the top 10 currently (the one exception is consumer discretionary).
To throw some numbers around the change in volatility assumptions priced into the market we’ll use the SPY because it is a deep and liquid market. If you compare the price of protecting against a 5% correction by the June 16th contract expiry, you had to pay ~35-40% more for those options yesterday vs. last Thursday, and that’s not adjusting for the lost time value (36 vs. 29 days to expiry).
These markets are really just another way we use our process to find attractive structures to fade the shorter term manic market moves within our intermediate to longer term views – “buy low” and “sell high”….
I know for sure that options markets aren’t as opaque and lightly-traveled as the private market for small business acquisition, but we at least hope to bring another layer of robustness to our idea-generation process.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.18-2.44%
SPX 2
NASDAQ 6007-6198
VIX 9.28-15.94
EUR/USD 1.07-1.12
GBP/USD 1.28-1.30
Oil (WTI) 45.69-50.40
Gold 1
Copper 2.46-2.56
Good Luck Out There,
Ben Ryan
Macro Analyst
