Friday, March 26, 2021

These Markets Are Designed To Explode

The binary nature of today's risk markets has grown more acute over time. Over the past decade non-stop central bank market intervention has ensured that most of today's hedge funds and algorithmic bots are using trend-following strategies. Latecomer Millennial gamblers have piled on at the end of a decade+ rally. Which means that everyone is on the same side of the boat...

When this all explodes, people will ask the same question they always ask - how did we not see this coming? For most pundits, the crashes of 1929 and 1987 stand out as the most abrupt and violent crashes of all time. However, the crash of March 2020 beat both of those by a country mile. Here we see the number of days it took for the market to go from an all time high to down -30%. Last year's crash was 3x as fast as both of those famous prior crashes. 

There are three well known and well ignored market factors that are amplifying rallies and crashes. One factor is what are called volatility targeting strategies. These trend-following strategies use historical volatility to determine the amount of leverage to apply to the market. As the market climbs, realized volatility naturally falls, so these bots add more leverage into the market top. Unfortunately, volatility is mean reverting so as the market falls, these bots sell at the speed of light. Then there are outright momentum following strategies called "CTAs". These machine-based strategies originated in the commodity markets hence they are called "Commodity Trading Assets". However, they have now taken over stock markets as well. The way they work is quite straightforward - as the market rises they add leverage, and as momentum reverses they sell. The third factor - market manipulation using options - garnered a lot of press coverage during 2020, but the inherent risk was ignored. Using call options, Reddit day traders essentially rent capital in order to manipulate the market higher. Market makers on the other side of the trade are forced to hedge by buying the underlying assets.

Over the past year, market manipulation using options reached record highs:

In the context of record central bank stimulus, these trend-following strategies have essentially taken over the market. Then of course you have the mob of Millennial latecomers who decided to wait for the end of the cycle to discover investing. Jim Cramer and Cathie Wood inform us that these newbies are "changing the way people invest" - meaning waiting over a decade to join the party is the new investment strategy. 

What makes this set-up far more lethal than last year is the fact that central banks are ALL IN, retail traders are on record margin, and the market is far more overbought than it was last year. Also, last year there was a massive rotation from cyclicals to Tech stocks. This year, Technology stocks are leading the decline and gamblers have been buying the dip all the way down. 

Another risk of course is the fact that Wall Street is dumping record amounts of junk SPACs into this market. And they will continue to do so, until the market explodes. It's a tradition, so why stop now?

All of which widely known and widely ignored risk factors will combine to make this the fastest and most lethal "unforeseen" crash in market history.

Risk is binary. When volatility reverses, and leveraged buying turns into leveraged selling, those who are trapped in the casino will be fighting with other gamblers to get out a non-existent exit.

Those who believe that central banks can reverse a bear market in a matter of a few weeks, have never been through a bear market. Their only experience in markets is buying into the end of the biggest bubble in history while believing that it's the beginning of a whole new cycle. Ironically, what the COVID bubble and the Dotcom bubble have in common is that they were both Tech stock blow-off tops coming at the end of the longest expansion in U.S. history. Prior to this cycle, 1991-2001 was the longest cycle. Similarly, what launched the final moonshot into Y2K was the LTCM/Asian Financial crisis and the global central bank liquidity bonanza that ensued. 

Good times. 

In summary, at the beginning of this cycle Millennials were Occupying Wall Street, at the end of the cycle they are getting blown up by Wall Street.

You can't make this shit up.