Dumb Money JPY Short

I’m going to be the chump and jump on the short JPY bandwagon. I have a low tolerance for risk here, though, so I’ll probably cut with a stop-loss of 0.5% (I sold at ~0.008644 or ~115.68 on the Dec 15’14 futures). I’ll take any loss as a lesson to not screw with Mrs. Watanabe.

The QE news is well known, but currencies will take time to adjust. Structural adjustments will take even longer to flow through (pension reg changes, etc). Abenomics version #1 (Nov 2012) lasted months. I have no reason to believe version #2 won’t last as long (after all, economic data will come at low to medium frequencies).

(On a side note, I put in a tiny long in SLXP after discussion with a friend on Friday).

Delevering Sooner?

I don’t think I can wait for S&P 2,100 anymore. Turkeys, Santa, Jeremy Seigel, and indomitable holiday optimism would have us believe that the only way to live is long and strong. But last night, I experienced a most ominous dream.

In my dream, I was at the RentHop offices with my IB terminal open. In the place of our Director of Product, though, sat George Soros. I looked over at his screen and saw him closing all his positions. I quickly copied him. After all, who am I to question the grand master of reflexivity? A few minutes later, the markets toppled and collapsed.

Maybe I had the dream because of the leverage I’m running. Or perhaps it was from the Soros article I read right before I went to bed. Either way, I’ve found that my dreams have been surprisingly prescient (in fact, I dreamt something similar in mid-September).

There are certainly cracks in the system appearing. Fighting has broken out yet again in Ukraine. ISI is portending potential earnings readjustments. More importantly, we’ve pretty much staged a full V-shaped recovery since October.

I think starting early/mid next week, I’ll move deep ITM long options positions into OTM call options (with slightly lower delta). Implied volatility has dropped like a stone since mid-October, so this is a safer way to play potential rallies. I might fund these with 1×2 or 2×3 on the call side.

George Soros

Bullets and Bazookas

I’ve decided to cut risk today by around 15% (I still remain very long and very bullish). The general risk reduction applies to my entire portfolio, but I’ve largely undone the extra EUR short that I put on on the 22nd (risk/reward seems lower here + I’m tired of waiting for actual ECB action). This is in light of the decrease in positive “tail risks” that I see. I’m going to target roughly 2 – 3% in daily volatility into the New Year (and will adjust accordingly if vol increases). I’ve also reduced gamma on near-dated options to prevent theta burn.

Positive Pressures

  • Earnings drift – US earnings growth will continue to be a positive going forward. Annually (assuming constant multiples), that means roughly ~4-5% of nominal appreciation.
  • Global QE flow-through – Implementation of QE & balance-sheet expansion actually matters (not just the announcement). This will cause a constant pressure up in the next year or so.
  • Continued buybacks & corporate action – This will serve to lower the “duration” of stocks (if we think about stocks as a CF stream). Perhaps it also means less sensitivity to rates and implied risk premium.
  • Seasonal effects – Everyone loves turkeys and Santa.
  • Short-term cheap oil – In the near-term (and through the holidays), the cheaper oil should have a non-trivial effect on spending. Perhaps it’ll be a retail bonanza this year.
  • Low interest rates forever – At this point, I’m solidly in the “global deflation export” camp. We’re going to be getting cheap capital from around the world in perpetuity. Sadly, it’s up to us to carry the world.

Negative Pressures

  • China “Harder Landing” than expected – Market news has been remarkably quiet about China in recent months. Everyone seemed to shrug off the weaker GDP and PMI numbers. So far, the PBOC & the Chinese government have the situation under control. But I’m a bit worried about this one… quite worried.

China Housing

  • Bazookas fired & bullets expended – For now, it appears that the Central Banks of the world have run out of bullets to fire. We’re still anticipating some “great action” by the ECB but that might be a story for next year. Until then, though, everyone is in wait-and-see mode. The PBOC still has bazookas to fire, but will likely only use it if some drastic event happens.
  • Perceived “bubbles” & extended multiples – I don’t believe the S&P is overvalued. In fact, with certain assumptions, we might even be undervalued (See this old gem by Damodawan). However, given the 5-year bull market, we’re seeing stronger calls by bears. The fear is there, and will potentially result in repricing of risk. However, this is not the global top (if a top at all).
  • Eurozone In-action (but more bucket kicking) – I have little hope of any real change in Europe until shit really hits the fan. Their system is in more gridlock than Republicans & Democrats. More indecision there (coupled with any more negative growth news) will add negative pressure.
  • Sustained low oil prices – I don’t actually expect this to happen. But a lot of “bad things” can happen if oil prices remain too low for too long. Sure, we’ll have positive flow-through to the US consumer, but we’ll also damage one of the main growth sectors in our economy. Perhaps more worrying, I foresee massive tail-risks from the collapse / weakening of oil-dependent nation (particularly Russia & Venezuela).
  • “Stronger” dollar – will be bad for multi-nationals. But might lower input prices for some.

Bullets Expended

  • Draghi’s jawboning – I don’t know how much longer he can jawbone markets without actual significant intervention. He’s promised a lot, and we’ve priced in a lot. Plus there appears to be some real drama at the ECB.
  • More US QE – It’s possible, but only if we double dip or the recovery stalls. However, we shouldn’t expect more QE into growth. Again, Yellen Straddle (no longer Put).
  • Ebola “Hype” Recognized – The scare is over. Ebola was never a “real” threat to the US. But judging from the impact, you’d have thought 9/11 happened again (airline stocks dropped ~30% in September / October!).

AAL Drop

Bazookas Fired

  • Japan seems to be executing the ultimate Hail Mary. They’ve decided to sac the Yen in a last-ditch effort to bolster the economy. I have my doubts, though, given lingering structural issues. One positive, however, is that pension rule changes will likely add a massive tailwind to global equities (mostly the US). Will also cause continued pressure on JPY.

Looking Forward (2015)

Now that the most recent “correction” is over, I’ve decided to reassess many of the strategies / themes I’ve followed. I’ve decided on the following:

New Themes
Neutral Rates – Europe and China will be exporting capital / deflation. US, however, will be strong. We might see the end of QE, but the path of rate increases will be slow.

Yellen Straddle – Taper be damned… It’s pretty clear that the central banks of the world are here to jawbone (or, in extreme cases action) stability. Not just economic stability, mind you, but also asset stability. The Yellens, Draghis, and Zhous will be replicating a short-straddle position accordingly.

Some people have been talking about the “Last Great Bubble” (belief in the Central Banks). Perhaps it’s true, but it’s not something to worry about in the short-term. Globally, the political willpower is there to bolster the economies of the world. The bubble will only burst when we receive a negative shock so large that we don’t have the political willpower to act.

Maintained Themes
Long Beta – We are in an era of low volatility (aside from potential spikes) and moderate earnings growth. Multiples will likely stay inflated for some time, making slightly levered beta a decent Sharpe proposition.

Long Activism – We continue to have cheap debt and share buy backs. The activists have become more vocal and powerful over the last year. I bet along with them.

Long IQ – Where would the best and brightest of Harvard, MIT, etc. go? Software AI are highly levered, and the returns on raw intelligence will be high for the next decade. I don’t believe the intelligence premium is recognized properly (I might have to test this at some point using scraped LinkedIn data).

Dropped Themes
Short Rates – Given negative carry, I don’t believe following the Goldman strategy is the way to go – especially since the world around us is slowing down. The risk/reward just isn’t there.

Long Growth – The easy money has been made in growth. Earnings growth will be more consistent/stabilized. The long growth names might be more priced to perfection at this point than we believe (ex: NFLX, AMZN). I don’t have a sense of where they should be valued at this point, so I will stay away.

Current portfolio positioning (ratios based off of my ES Delta). Yes, I got mildly spanked by AMZN post-close.

Positioning

Shorting more Euros

I added to my short EUR position this morning. This is an extremely crowded trade, but likely less crowded in the recent shakeout. The drift is down – but might be accompanied by sharp spikes (given positioning). I’m fine with that.

* I don’t care what Merkel thinks, austerity doesn’t work.
* Eurozone politics are worse than ours.
* 10-year Bunds < 1%. UST will probably stay at > 2%. Regardless, we’ll have positive rate differential / carry for a considerable time.
* US is not the epicenter of deflation/slowdown. Flight to safety will be towards dollar.
* US is in a tightening cycle (though probably slower than people think). ECB is contemplating buying corporate bonds (what?).
* These long-term themes generally take considerable time to play out. I will stay on the bandwagon until the assumptions no longer hold.

Will show better analysis later.

VIX and Returns

I’ve read numerous articles attempting to use the VIX (or a normalized VIX) as an indicator of market bottoms. In fact, CNN introduces it as the first factor in their “Fear and Greed” index. But instead of forecasting and prediction, perhaps we should be looking at it in a different way…

More risk should be compensated by more reward. VIX (which is constructed using the near and next-term options) does a fairly decent job of predicting forward volatility (top right). However, we don’t see a similar pattern in returns (especially in the 18-25 buckets). In fact, the forward returns drop in the 18-25 bucket. This is the case even when removing the 2008 financial crisis from the data set.

Possible conclusions?
1) When things get bad and uncertain, they’re liable to get more bad and uncertain (dumping positions is a valid play).
2) Market participants (in general) are more long than short. Given some level of leverage, higher volatility -> higher required portfolio margin -> more selling. By the time we get to > 25 (~1.6% moves / day), all the speculators have already been shaken out (hence, why the risk/reward normalizes).
3) I’m fooled by randomness (especially given the market crashes in the last decade) and the risk/return is actually consistent across vol buckets.
4) I’m fooled by bad math and faulty statistics.

VIX Forward

* Includes ~ 14 years of data, starting in 1/1/1990 (the back-filled VIX data).
* I haven’t looked at it 2nd order (ie, changes in VIX), but something I want to explore.

Not a way to live

It became blatantly obvious mid last week that things had gone horrifically wrong. So wrong, in fact, that the intra-day volatility inflicted Ebola-like symptoms upon me.

You see, I distinctly remember the day when my professor taught me to model VaR using a GPD (or otherwise fatter distribution). Unfortunately, the IB Risk Navigator lulled me into a false sense of security. A costly novice mistake.

As I recover from this travesty of a month, I’ve decided that being ultra-levered is not a way to live. I’ve established this blog not only to share my thoughts about the markets & tech — but also to second-guess potentially blunderous and impulsive trades.

P&L 20141021