People Are Worried About the Stock Market
(Bloomberg View) -- People are worried that people aren't worried oh wait no.
On November 30 of last year, the S&P 500 Index closed at a new all-time high of 2647.58, up 18.3 percent for the year thus far. Two days earlier, Bloomberg Markets had published "What to Worry About in This Surreal Bull Market." "Equities keep hitting record highs and volatility hovers near historic lows, all while geopolitical tensions abound," the article began, and then it compiled worries from investors and strategists and pundits who worried that the party would eventually have to end. Would leveraged quant-fund unwinds finally bring down the long bull market? "Some sort of cyber event"? Weaknesses in China's financial system? Stresses to stock-exchange closing auctions? Over-reliance on index funds? Contagion from a Bitcoin crash? Concentration in repo markets? Really anything was possible; a long period of calm optimism had given people a lot of free time to imagine horrible counterfactuals.
Yesterday the S&P 500 closed at 2,648.94, a hair above where it ended last November.
So what to make of it? If you slept through December and January and last week and, above all, yesterday, and you woke up today to find the market up 0.05 percent over the last couple of months, I suppose you might conclude that the surreal bull market had quietly sputtered out. You might go back and re-read that list of worries and be like, well, sure, this list of worries is worrying, I can see why the market stopped being so uniformly optimistic, perhaps an even mix of optimism and pessimism is warranted and stock prices should drift up more slowly than they have been for the past few years.
Of course that was not the experience you had if you were awake for the last couple of months. What actually happened is that the market kept cheerfully going up, hitting a closing high of 2872.87 a week ago Friday. Then it spent last week fading, and got routed yesterday, with the S&P 500 down 4.1 percent and the Dow Jones Industrial Average down 1,175.21 points, the largest point drop in its history. "This is the first time in a while I’d say it feels like borderline panic-type selling," said one broker, which is a pretty nonchalant sentence considering that it includes the word "panic." Ehh, I guess a little panicky, whatever.
So with hindsight, what should we have worried about in that surreal bull market? Hahaha no that is a trick question, there is no "hindsight," in general it is no more obvious what caused a market crash after it happens than it was obvious what would cause the crash before it happened. It probably wasn't Bitcoin contagion? (Maybe?) It doesn't seem to have been the cyber?
But here is Ray Dalio of Bridgewater Associates arguing that "We’ve Just Had a Taste of What the Tightening Will Be Like": "The surge in growth and wages came because of both the fiscal stimulation and the rekindling of animal spirits, thrusting the economy into late-cycle capacity constraints, which is leading to the expectations of faster Fed tightening." "Payroll figures that showed more jobs and more pay for Americans sparked" the decline, writes James Mackintosh, which will be a blip if it leads to a bit of Fed tightening but a real problem if it instead leads to serious inflation. Bloomberg News rounds up explanations, which include worries about Treasury yields and Fed tightening but also "stretched technical indicators," "short volatility pressure" and "extended valuations." My Bloomberg View colleague Tyler Cowen argues that high asset prices reflect a demand for safety, and that "as positive reports percolate and spread throughout the American economy, and perhaps in much of Europe too, blue-chip assets become less important as relatively safe stores of value and so their prices might fall." Or maybe the markets were just hazing Federal Reserve Chairman Jerome Powell on his first day of work.
All of these explanations are probably right, but remember that just two months ago all anyone could talk about was how the market was too blasé, overheated, ignoring big economic and geopolitical risks, a "surreal bull market." And stock prices are higher now. There is a path dependency to any explanation of market moves. If stock prices had moved smoothly up by 18 percent over the last 14 months, all we'd be talking about today would be how people are worried that people aren't worried enough. Instead they moved up by 28 percent and down by 8 percent, ending up in the same place but with a very different narrative.
Meanwhile: "Machines Had Fingerprints All Over a Dow Rout for the Ages," says this headline, but I am not fooled, I know that the machines do not have fingers. Did they cause the crash? A Florida broker says yes:
“We are proactively calling up our clients and discussing that a 1,600-point intraday drop is due more to algorithms and high-frequency quant trading than macro events or humans running swiftly to the nearest fire exit,” said Jon Ulin, of Ulin & Co. Wealth Management in Boca Raton, Fla., in an email.
A high-frequency trader says no, or no-ish, or not in a bad way anyway:
“There was not a single self-help; there were no outs; there were no fat fingers that we saw,” Doug Cifu, CEO of high-speed trading firm Virtu, told CNBC. “There were no busted trades, no repricing. It was just an avalanche of orders around 3 o’clock-ish.”
But sure, in a sense, machines, why not:
“Midday today, short-term momentum turned negative, resulting in selling from trend-following strategies,” [JPMorgan Chase & Co. derivatives strategist Marko Kolanovic] wrote in a note to clients. “Further outflows resulted from index option gamma hedging, covering of short volatility trades, and volatility targeting strategies. These technical flows, in the absence of fundamental buyers, resulted in a flash crash at ~3:10 pm today.”
You can use words like "technical" and "gamma," but I am still not fooled. The computers did not discover trend-following. Trend-following is a thing because humans follow trends: Humans so predictably buy when stocks are going up and sell when stocks are going down that you can program a computer to profitably imitate that behavior. The machines are not panicking. The machines do not feel feelings. If the machines look like they are panicking, it is because they are imitating the humans.
There is a certain snobbery in certain circles about describing certain things in terms of percentage moves. You can certainly talk about price moves in percentage terms: If you buy a thing for $100, and it goes up to $150, you have 50 percent more money, and saying that it is a 50 percent move is straightforward and normal. But people sometimes talk about changes in more abstract mathematical quantities in percentage terms, and other people sometimes get annoyed about it. Volatility, for instance, is already a percentage. If your stocks move by 1 percent a day, then loosely speaking you have 16 percent volatility. If they start moving by 2 percent a day, then loosely speaking you have 32 percent volatility. Your volatility has increased by 100 percent. Your daily price moves are twice as big as they used to be. It's just that they are 2 percent instead of 1 percent, so there is something a bit melodramatic about saying that they are 100 percent bigger. They're 1 percentage point bigger.
And so there are purists who would object to sentences like "the VIX surged by 116 percent, the largest one-day move on record for the gauge." The CBOE Volatility Index, the VIX, is a measure of short-term expected volatility in the S&P 500 Index; it closed at 17.31 on Friday and 37.32 on Monday. That is a 115.6 percent move, but, eh, you know, it is also a 20 percentage point move, and off a pretty low base.
But the great thing about modern finance is that it inexorably turns abstract quantities into prices. The VIX is not investable -- you can't buy the VIX for $17.31 or whatever -- but you can get pretty close. For instance there are VIX futures, and exchange-traded products based on those futures that attempt to capture the daily changes in the level of the VIX. If you owned the iPath S&P 500 VIX Short-Term Futures exchange-traded note (ticker VXX), then you were up ... huh, well, 33.5 percent yesterday, a nice day but not quite the 115.6 percent gains you might have hoped for. (The VXX "continued to climb in post-market trading, shooting up as much as 48 percent since the close.").
If on the other hand you owned the VelocityShares Daily Inverse VIX Short-Term ETN (ticker XIV), or the ProShares Short VIX Short-Term Futures exchange-traded fund, which are meant to provide the inverse of the daily VIX performance, then you were ... hmm ... [rechecks calculations] ... yes it says here you were down 115.6 percent yesterday? I mean, you weren't. For one thing your downside is limited to 100 percent; you can't owe the ETN more money than you invested. Also, the ETN's formula is futures-based and doesn't exactly mirror the daily VIX. And XIV was actually only down 14.3 percent during the trading session -- though it fell another 81 percent after hours and was halted for trading this morning. Credit Suisse AG, the issuer of the XIV note, has the right to shut it down if its value on one day is below 20 percent of its closing value the previous day, an action it took this morning.
That seems ... right? If you bought a thing that was meant to give you inverse exposure to the daily moves of the VIX, and the VIX was up 115.6 percent in a day, then you shouldn't have that thing anymore. If you have any money left over in that thing, that means it was not giving you the experience you signed up for. The experience you signed up for was inverse daily VIX; in the actual state of the world that obtained, that experience turned out to be losing all your money. "The XIV ETN activity is reflective of today’s market volatility," boasted a Credit Suisse spokeswoman in response to questions about its drop/halt/disappearance. High-fives everyone! It worked exactly as intended.
The basic way that XIV works -- worked -- is that you short volatility to Credit Suisse, and Credit Suisse hedges that by shorting volatility to the market. More specifically, Credit Suisse presumably hedged its XIV exposure by selling VIX futures. The bigger XIV got, the more VIX futures Credit Suisse had to short, driving down the level of the VIX (and, perhaps, driving down actual volatility in the stock market). And over the past few months and years of low volatility, XIV kept getting bigger -- short-volatility exchange-traded products reached over $3 billion of assets -- and Credit Suisse sold more VIX futures to hedge it. That drove the VIX down more, which made the short-VIX trade more profitable, which pulled more assets into products like XIV.
But when XIV basically went poof in a day, Credit Suisse had to buy back all of those VIX futures. That drove up the price of VIX futures, exacerbating both volatility generally and XIV's losses specifically. The low-volatility bets that had been pushing down volatility for months pushed it up yesterday.
But the nice thing about XIV going poof in a day is that it's done now:
Those products “have effectively been wiped out," Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors, wrote in a note. Still, “the short vol products have covered 95 percent of their risk, meaning that the ‘VIX blowup’ event has effectively already happened. If the upward pressure on VIX (and to a lesser extent, downward pressure on S&P futures) was driven mostly by the VIX ETPs, that source of pressure is gone," he wrote.
Goldman Sachs research notes that "the VIX ETP market landscape has shifted substantially" and is now net long a lot of volatility. Long-volatility exchange-traded products, like VXX, should have roughly doubled when the VIX was up 115.6 percent; their bets that volatility will go up are now bigger. Short-volatility exchange-traded products, like XIV, should have roughly disappeared; their bets that volatility will stay low are now gone.
How are things at Morgan Stanley?
Erik Schatzker interviewed Morgan Stanley Chief Executive Officer James Gorman for Bloomberg Markets, and Gorman, a former lawyer and consultant who was initially hired to run Morgan Stanley's wealth management business, is excited about ... fixed-income trading:
JG If you look at fixed income, the irony is that could be our biggest winner in the next several years. It was a serial under-performer. We restructured it a couple of years ago under the leadership of Colm and Ted and Sam Kellie-Smith, and they’ve done a great job. The markets have been unbelievably light in fixed income, in volume and volatility. That will turn, so fixed income might be the sleeper.
ES Does the looser regulatory environment create opportunities?
JG That and rising interest rates. You could argue we have the perfect trifecta right now. We’re going to have lower corporate taxes, we’re going to have higher interest rates, and we’re going to have a more balanced regulatory environment. So after 10 years of having zero interest rates, extremely demanding regulatory processes—a lot of which were needed—and very high corporate tax rates in this country, all of that is changing at the same time. That’s an inflection point. So the banking sector is in for a very interesting run in the next few years if the global economy cooperates.
How should you feel about a big investment bank CEO touting bond trading and saying that "the banking sector is in for a very interesting run"? I feel like there will be worriers. I mean, I feel fine about it. I find interesting things interesting! One thing that we talk about from time to time around here is that since the financial crisis regulators have worked hard to make banking boring, and they have had a great deal of success, and the result is probably a less risky financial system, possibly a less dynamic financial system, but certainly a less interesting financial system. If your criteria are essentially aesthetic -- if you want bankers to amuse themselves at work, and to amuse the rest of us with their products -- then you will probably welcome a slackening of that regime. My assumption is that most bankers' criteria are essentially aesthetic, and that they will be excited by the prospect that banking might soon be fun again.
You can tell that this is essentially an aesthetic rather than economic excitement because banking's newfound interestingness won't really translate into pre-crisis levels of return on equity:
ES It took a long time for Morgan Stanley to get back to 10 percent ROE. Could it once again be a 20 percent ROE firm?
JG Not in my career. You can’t do it. Not with the leverage ratios, not with the amount of capital. And remember, when we were a 20 percent ROE firm, it was based upon 30 times leverage. So you can argue it was fake. In this world of fake news, those were fake earnings. By the way, during the crisis, a lot of those earnings were given back. So, no, our aspiration is not to be a 20 percent ROE firm. The only way to achieve that is to take our levels up to a level we’re not prepared to take them to.
One crude view you could have of banking is that banks do some stuff, and the stuff makes some money with some amount of variance, and if you lever the stuff up 30 times it gets very exciting indeed, while if you lever it up 8 times it is kind of meh. The interestingness or boringness of banking is a function of the leverage dial. I take it that that is not Gorman's view, and rightly so. Adding leverage is the least interesting way to make banking more interesting. Adding intrinsic interestingness -- doing new stuff, not just leveraging the old stuff more -- is where the action is.
Look, I don't know why stocks went down yesterday, and I don't know why Bitcoin went down yesterday, and I don't envy anyone who has to write market commentary about any of it, and I appreciate this effort:
“Although no fundamental change triggered this crash, the parabolic growth this market has experienced had to slow down at some point,” Lucas Nuzzi, a senior analyst at Digital Asset Research, wrote in an email. “All that it took this time was a large lot of sell orders.”
I mean, that's all it ever takes! Bitcoin, the least fundamental of all assets, was down about 17 percent yesterday and was trading at about $6,675 as of 8 a.m. today, all, let's just say, based on "no fundamental change."
Meanwhile Nathaniel Popper looks at the cryptocurrency industry in the light of the Bitcoin crash and does not like what he sees: "Signs of trouble have appeared at nearly every level of the industry, from the biggest exchanges to the news sites and chat rooms where the investment frenzy has been discussed." This is perhaps the best crypto anecdote I've seen yet:
A new virtual currency, Proof of Weak Hands Coin, whose creators referred to it as a Ponzi scheme on Twitter and use a pyramid as a website logo, raised $800,000 before hackers got into its systems last week and drained its funds.
A crypto Ponzi scheme got hacked. It's like a Guy Ritchie movie. They openly advertised to investors that it was a Ponzi scheme, and the investors invested anyway, and then they got something worse than a Ponzi scheme. Eventually there's going to be a fraudulent crypto Ponzi scheme: Like, the promoters will advertise that it's a Ponzi scheme, but they will actually just steal the money and not even bother to Ponzi it, and then -- I hope -- regulators will bring charges saying that investors didn't get the Ponzi scheme they were promised. Honestly! If you sign up for a Ponzi scheme and your money gets stolen by hackers, you need to re-evaluate every aspect of your life.
Here are some notes taken by John Bares, then the head of Uber Technologies Inc.'s autonomous vehicle group, at his meeting with Travis Kalanick, then the CEO of Uber, in December 2015 to discuss what Uber hoped to gain by acquiring Otto, an autonomous-vehicle company started by former Alphabet Inc. engineer Anthony Levandowski:
TK what we want
all of their data
pound of flesh
Alphabet's Waymo unit is now suing Uber, claiming that it hired Levandowski in order to steal Waymo's trade secrets, and Waymo introduced those notes on the first day of the trial yesterday. I suppose they are good evidence that Uber hired Levandowski to steal, you know, Waymo's source code and all of its data and its intellectual property? Since ... that's what ... Kalanick ... told Bares to do? But not a pound of flesh. Levandowski did not, so far as I have heard, walk out of Waymo with a pound of human flesh in a jar.
The problem is that when you get sued a lot, and you have a CEO who speaks in exaggerated metaphors, and you take written notes, then you have to explain a lot of awkward stuff to a jury. "The golden time is over. It is war time," Kalanick said, in another set of Bares's notes. And: "Cheat codes. Find them. Use them." "We’re bringing this case because Uber is cheating," said Waymo's lawyer in his opening statement, and it is convenient for him that Uber's own documents called for cheating. Oh no they didn't, of course not, Kalanick no doubt meant "cheat code" as a more general term of approbation than as a specific call for cheating. It is just, you gotta be careful with your words if they're going to end up in court.
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Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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