Sunday Sketches June 23, 2024
A brief look at risk, biblical insurance salesmen, and a timing update for future posts (spoiler, starting 7/8 I'll be sending these out on Mondays).
“It’s a foolish man who builds his house upon the sand” - The Bible
“It’s an even greater fool who provides insurance for a house built upon the sand” — Leonard
If you aren’t familiar with the work of John Hussman, or have not read his recent work, I recommend checking out his interview on Thoughtful Money from this last week (week below).
John is one of the best at putting numbers to current market conditions and mapping out what similar past market conditions meant for future returns. Now, there is no shortage of number geeks in the financial world but I appreciate that John also considers “risk appetite” and “psychology” in his views.
You’ll hear in the interview that he keeps stating “this is not a forecast” but an encouragement for people in the market to examine their “risk exposure”. Now, you don’t have to be Sherlock Holmes to figure out what he really is saying is “hey fool, this market is uber-crazy and supper narrow, if the future is anything close to the past then you’re going to lose your butt”.
But here’s my question that I wish John had been asked. “Why should I be worried about the market tanking if I can currently buy insurance on my long position for so cheap?”
Consider that currently one can buy an ATM Jun 2025 Put for 4.3% of the strike price. Back out the 1.3% dividend yield you would receive on a long position and you’re down to 3%. If you’re willing to cap your gain at 10% between now and June 2025, sell an OTM call and that 3% is 0%. A free roll basically. Zero chance of loss, but up to a 10% gain.
If this seems a bit crazy, it should. Now you do have to consider the opportunity cost of getting 5% risk free in t-bills, BUT this still leads me to ask the question.
Is the fool the one who has his house on the sand or the one providing insurance on said house?
If you follow me on Substack (and why wouldn’t you?), you would have seen the two charts below over the past few days.
Showing that while the headline SPX continues its march higher, overall risk appetite is below the 50th percentile and my price oscillator is not keeping pace (i.e. momentum is waning).
Now Mr. Hussman believes (and I generally agree) both are troublesome signs for an over extended market (read loft valuations). If you recall we covered last week the problem with narrow breadth. BUT, who really sells a market when you can hedge for next to free?
Leaving me to argue, that before bears get any traction the price of insurance (i.e. put options) has to rise.
Now, we’ve covered in weeks prior the money that has flooded in to volatility selling funds, and that the short VIX etf (SVIX) has provided Nvidia like returns since May 23 but this isn’t just a trade gone wild. It’s enticing to sell something that keeps going down and volatility has done just that. 1-year historical volatility scrapping along the bottom of the historical range (chart below).
And a BIG part of the reason has been that correlation between SPX components has been making record lows (with the trend “expected” to continue, chart below). As you’ll recall, we covered in past weeks how this lack of correlation keeps volatility of individual stocks and sectors from jolting around the headline index (with correlation low, their movements cancel each other out).
The TLDR. Insurance stays cheap (market stays up) as long as correlation (and thus realized volatility) stays low.
Unless you’ve been living under a rock, you’ve probably heard about “AI” in the past year or two. At a time when the broader economy has languished, “AI” has made darlings out of a hand full of tech stocks (I won’t bore you with how the concentration of the top 3, 5 or 10 S&P 500 stocks is heavier than ever, or close to).
So, a handful of giant market cap stocks surging, the rest of the market flat to down…sounds like some low correlation. Bingo.
The TLDR. “AI”, mega cap tech keeps dominating the market, insurance stays cheap (market stays up) as correlation (and thus realized volatility) stays low.
So what could rain on this low correlation parade? Well:
The rest of the market could also start going up (the ever awaited “broadening of the rally”) which may ironically raise volatility; But it’s hard to paint this as a bearish scenario (or as a likely one unless economic data and risk appetite does a u-turn quickly).
“AI” could lose its luster (1st and 2nd image below)
Or a mass deleveraging event could occur, say recession fears (3rd image) or maybe a pause in corporate buybacks (4th image, though this would be short lived)
One of the most interesting podcasts I’ve heard in a while was Ben Hunt of Epsilon Theory on Capital Allocators (link below):
Ben focuses on the power of narrative in the podcast but what I found most intriguing (and timely was his work on common knowledge).
The way I understand it, is often a majority of people privately believe something (or have experienced something) e.g. seeing the emperor with no clothes; BUT we do not know if other people know the same. That it takes a “missionary” (a public information spreading event) to let us all know, we all know (kind of like when an 82 year old president has a debate and comes across as having wandered loose from shady acres, we all know what we saw folks).
I bring up the above because I think there are two scenarios where we are all (on some level) building some private knowledge, but there has yet to be a “missionary” proclamation to let us know that we all know.
There is lots of “hype” around AI but no one seems to be finding real revenue generating uses cases for it. We’ve experienced the “embarrassing” AI interactions, 18+ months post Chat GTP our lives aren’t really different, and anyone with two brain cells to rub together can assume that the deluge of orders for AI chips is likely an s-curve type event.
The economy is slowing. Labor market is weakening. Consumer sentiment stinks. But (as of yet) we still hear from a Fed worried about resurgent inflation (i.e. reaccelerating growth) and a BLS that keeps plopping out pumped up job #s. The below sounds like a world waiting on observations to become common knowledge.
Now, when or if these “missionary” events occur, to turn the above from private observation to comment knowledge, I don’t know; But I do know, if they occur they would certainly create the mass deleveraging mentioned in #3 above and we’d pretty quickly head down the spiral of:
Correlation up
Volatility up
Price of house on sand insurance up
Those with houses on the sand having a fire sale
Market tanks
Correlation goes up more
Volatility up more and so on…
So to wrap things up. I agree with Mr. Hussman, some people do need to examine their risk exposure but I’d argue it's those milking every last drop out of the houses on the sand insurance bonanza. I hope everyone else has some cheap puts in their back pocket.
Lots of big data coming this week and the start of a new quarter. Will we see correlation rise? I think the answer to that question tells us a lot about where things stand a week from now.
Until next Monday, cheers!
June 30th’s