Acceleration of market trends - due to COVID or new normal?

[jacob]

Beta-ripping is when individual issues get severely mispriced when their price moves a substantial distance over a short (intraday) time because of a total market move that's responding to news that's not economically affecting the entire market.

For example, negative virus news gets traders to drive down the SPU. This in turn drives down the SPY and so individual issues get arbed down as well, even issues that should do well on negative virus news e.g. CLX or JNJ.

It can also be more indirect. E.g. great numbers for AMZN drives up the Giant5 which in turn drags NDAQ along (the Giant5 is 45% of NDAQ). This is turn moves biotech (another big sector in NDAQ) up for no other reason than their strongly correlated beta.

Beta-ripping is when a stock moves [strongly] because of an index move rather than on individual issue news (that'd be an alpha-rip). In practice, investors can use this to either load or unload individual positions from/to indexers when the index moves fast. In practice, futures traders can't do much beyond "long NDAQ, short SPU" on bad virus news and vice versa on good virus news. Limited levers.

[Lucky C]

Gotcha thanks for the explanation!

[Lucky C]

Looking again at S&P 500 price history, I wanted to compare the past decade or so of market swings to previous decades/eras.

Even though this year's big swings aren't any more extreme than other historical crises, it may feel like trends/volatility are accelerating because we have had an unusually calm decade before this year, without any stretches of "moderate" volatility. This shouldn't really be surprising to those who have studied historical market cycles, but I made some charts which I think are an interesting way to have a different look at this.

The most popular definitions of market risk or chaos when looking at price returns are volatility or maximum drawdown over a given period. However as mentioned in a previous post I am looking at whipsaws (sharp moves down or up immediately followed by the reverse) because in my view those are more maddening and simply harder to adapt to, compared to trends that last several months to years. Other volatility measures would

I compiled histograms over different time periods of these "whipsaw magnitudes" which I define as the absolute value of the past month's (21 trading days) change in S&P 500 price, minus the previous month's change in S&P 500 price. I computed this for each day, so these are overlapping periods, each being 42 days in length.

This chart compares January 2010 - October 2020 vs. the volatile 2000's (tech bubble crash and GFC) vs. March 1928 through the 1930's (1929 crash and Great Depression). Left x-axis = calm waters, with not much difference from one month's return to the next. Further to the right represent wild reversals from one month to the next which would spell doom if you made any bets for an extreme price move last month to continue this month (but great for contrarians operating on this time scale). Note the y-axis is log scale.



The key point that I think is interesting is that the most recent decade+ is a multimodal distribution of very calm returns to the far left which of course are mostly pre-Covid crash, plus a ramp up to the chaotic right side on par with the crises of the 2000's, even though we haven't had long bear markets like in 2000-2003 and 2007-2009. The 2000's and the Great Depression era have a smoother distribution from left to right, with a lower occurrence of single-digit month-month reversal percentages compared to the calm years of the 2010's.

Now comparing the 2010's-present to the average from 1940-2009 (exclude Great Depression and most recent decade), as well as the "calmest" decade, the 1950s:



The 2010's have had an unusually high occurrence of extremely low month-month reversals based on the 0 - 3% bin even compared to the most calm periods over the past century. A lot of "things are quiet...too quiet" periods. Meanwhile the opposite end shows big month-month reversals occurring more often than the historical average (excluding 1928-1939).

Based on this, I view the "extremes" this year not as being extreme volatility spikes on their own (we have seen volatility like this during other big crises), but the extreme shifts between unusually calm periods and unusually volatile periods. If you've experienced a period of clear trends lasting several years (with the market moving consistently from month to month whether the trend is up, down or sideways), and suddenly a big drop is followed by a big recovery (or vice versa) the very next month, that could throw you off more than if the market was already somewhat volatile. Depending on how one makes investment decisions, this past decade may have been more psychologically challenging than other decades when the stock market did not do as well.

Seems like we should be prepared for not just the possibility of unusually volatile swings, but the possibility that we could suddenly switch to unusually calm waters. I don't think extreme calm is likely any time soon, but I also know that just because it seems unlikely to me, it would not be wise to bet against it!

[Lucky C]

And for completion here is the very busy version of the chart above showing all decades. The multi-modal distribution of the most recent period still stands out as odd compared to most of the others. The 1980's has the most similar response in terms of multi-modality due to the 1987 crash in an otherwise pretty calm decade.

[Mister Imperceptible]

https://papers.ssrn.com/sol3/papers.cfm ... id=3725454

[nomadscientist]

A few months is too short to talk about trends.

The black swan that will wreck everyone at this point is the stock market remaining nominally flat for several years with moderate inflation. Doomers are all betting on a big draw down (because it's backtested to work!).

[Mister Imperceptible]

George Soros said that when things get really bad, everything goes way up, not down. Nominally flat for years seems unlikely when the debt has achieved escape velocity.

[nomadscientist]

People are now talking openly that central banks have a mandate to stop the stock market ever [nominally] falling, including congresscritters. They already do that by creating money, but no one cares about inflation anymore. People cared about inflation in 2008, and what everyone remembers is the 2008 inflation doomers who bought gold under-performed the S&P500 and looked dumb. So moderate (not wild, Weimar-style) inflation wiping the fake gains seems the most likely outcome to me. Doesn't shock anyone, fits current academic prejudices, surprises the unwary with unexpected failure mode, and wipes the coronadebt. Barbell portfolio doesn't protect against it.

[Mister Imperceptible]

Everyone complains about the cost of housing, healthcare, and education, and soon they will be complaining about the cost of food and other necessities. But I do agree that the bought and paid for media and central bank statements will will say they do not care about inflation, or that they are unable to locate it, or that they wish they could generate it but are unable to, or something.

[nomadscientist]

To be clear I am not saying that inflation won't happen or even hasn't happened. I am saying that the lack of fear of inflation (also true among the general public AFAIK, not just media preference falsification) is making it more probable.

I was an inflation doomer in 2008. If I think back to the intellectual leaders of our movement at that time - people like Hayek, Rothbard, Friedman - they were all old guys who had got famous in the 70s and 80s. Some of them were actually dead already. Controlling inflation was still (just) seen as the hallmark of good economic governance, much more so than balanced budgets or even growth.

Of course not everyone was in that movement. But everyone was at least aware of it. Everyone knew that if there were big inflation, it would rocket in credibility and had political structures in place to maybe take power.

Today, most people under 50 have never experienced reported inflation as managers of their own finances. Food prices always stay the same. Rent always goes up, but so do stonks. There is no such movement today.

[Lucky C]

A few months is too short to talk about trends.

The black swan that will wreck everyone at this point is the stock market remaining nominally flat for several years with moderate inflation. Doomers are all betting on a big draw down (because it's backtested to work!).

We're sort of saying the same thing here with the difference being that my concerns are different than yours because of both how I invest and my psychological weaknesses.

Yes, a few months is too short to establish a trend, but extreme reversals from one month to the next can cause one to lose confidence or otherwise get into trouble (e.g. a trading model being whipsawed to death). A dip down one month can confirm what you thought was a trend forming over the past year, but when a big reversal happens the next month, it can be impossible to determine if it invalidates the trend, or is just continued volatility, a dead cat bounce, etc.

When you say that doomers are betting on a big draw down but you think equities will be flat for several years, that's certainly a possibility. We just experienced about a decade of abnormally smooth sailing followed by a rare wild ride. Now there are people betting on smooth sailing and others betting on the next wild ride. My point is that markets can switch abruptly from long stretches of low volatility to high volatility and possibly back again, without necessarily spending as much time in a moderate volatility regime compared to prior decades.

I believe the moral of the story doesn't have to do with predicting whether the next stretch will be flat or highly volatile, but to be prepared for unpredictable shifts between low and high volatility regimes. Of course there is the possibility that the next decade could be full of "moderate" risk like in the 1970's for example - smaller booms and busts without any record-setting bull runs or crashes. Counting on one scenario or the other (relying too much on predictions) can be fatal compared to being prepared for whatever shape the market takes.

[nomadscientist]

I agree that being spooked by month to month volatility is a behavioural problem. It isn't an investment problem unless you don't realise it's a behavioural problem. I disagree it gives any significant amount of information about trends. I would say trends are on at least a 10 year timescale. These are trends:


This is a 60/40 portfolio starting with $100k and no withdrawals. 10% of portfolios are noticeably down on where they started in real terms after 10 years. The 25th percentile is a bit over breakeven. This can happen when there's little volatility; the 1966 start date is the worst in history for US investors and it was not particularly volatile. Or there can be a steady run-up for some years and then all the gains can be wiped at the end.

If you're not willing to endure 10+ years of slowly losing money, you are not likely to be able to retire on stock market investments. If you are willing to endure that, I question why monthly volatility is an issue*. Currently, the financial press will get spooked by volatility by which they mean a 5-10% drawdown on a monthly timescale against the background of a 50-100% bull run on a 3-5 year timescale. Most of these people will be cleared out, not by the next big crash (which they expect will immediately come back and more, rewarding those who 'buy the dip'), but by the next big stagnation.

*I grant it's different for a short term trader but I express some skepticism that successful non-professional short term traders exist.

[Sclass]

Today, most people under 50 have never experienced reported inflation as managers of their own finances. Food prices always stay the same. Rent always goes up, but so do stonks. There is no such movement today.

Too bad. Stocks seem to be inflating the fastest. Well perhaps not as fast as education, but they are increasing in price for arguably lower yields.

I marvel at the AEP shares I bought for dividends twenty years ago that have tripled in price. Same old dirty power utility. Now it’s just worth three times as much for the same thing.

Maybe it’s ZIRP. Or maybe it is dividend yielding shares denominated in dollars costing more dollars. Around me it looks like anything the 1% is interested in owning goes up in price. I cannot remember the time I put money into an investment feeling I was paying an appropriate price for a safe yield. Nowadays I feel like I have to accept a pile of risk to squeeze out a decent return from money I put on the line. Luckily most everything else I need is sold at Walmart.

[Flurry]

We just experienced about a decade of abnormally smooth sailing followed by a rare wild ride. Now there are people betting on smooth sailing and others betting on the next wild ride.

For US-stocks only. US stocks had a very strong outperformance the last decade, especially the big tech stocks. That led to high valuations and many people see no reason to invest in anything except NASDAQ 100 stocks.
I see it as a chance for non-US stocks, real estate stocks and other underperforming assets to shine. The much lower valuations could lead to higher returns, at least I hope so as I capped my US-exposure at 40%.

These are the markets I hold in my ETF portfolio:
FTSE North America: P/E ratio 19.8 - Dividend yield 1.95%
FTSE Japan: P/E ratio 17.7 - Dividend yield 2.7%
FTSE Developed Europe: P/E ratio 14.6 - Dividend yield 2.9%
FTSE Emerging Markets: P/E ratio 14.4 - Dividend yield 3.0%
FTSE Developed Asia/Pacific ex. Japan: P/E ratio 14.2 - Dividend yield 3.8%

Compared to a market neutral portfolio that's probably a value/size bet, I know.

[Toska2]

The Matthew effect causing the top 10-20% of the market (FAANG) swing more wildly than the rest. This wouldn't show up in your nice graphs.

[7Wannabe5]

Where’s the emoticon for “Whoosh, over MY head!?” I did start reading “Investments” by Bodie, but I’m stuck going on gut for now, because I am too lazy to take care of meat rabbits.

[white belt]

I will attempt to explain another factor that Jacob hit in on a bit when he was talking about a lack of different investing strategies and specifically focus on passive investing. We are now at the point where passive investing is ~45%+ of market cap and this is large enough force to move the entire market.

Mike Green from Logica Funds talks a lot about this and has been researching the passive investing effects since 2016 (source):

Unfortunately, it does not appear that the combination of systematic volatility selling, passive investing and illiquid markets are going to disappear anytime soon. The currently elevated levels of volatility have made the absolute attractiveness of selling volatility more appealing. Those who avoided overleveraging their short volatility positions will return. Likewise, I am confident that the lobbyists for Vanguard and Blackrock are hard at work tapping into the likely supply of pork from Washington to expand the regulatory advantages of passive index investing. It is, of course, implausible that the market meltdown will lead to calls for reduced regulation and a reintroduction of contractual market making operations for individual securities (the specialist system). It is likely that ship has sailed permanently.

This highlights the dire need for strategies to express humility about certainty in the underlying direction of markets, and separately, to ensure more exposure to the extremes; whether violent recoveries or further collapses. If we are right and we are unlikely to see substantive changes to the market structure, then the unavoidable conclusion is that markets could aggressively reprice higher as money flows into passive strategies; this becomes particularly true if the United States is engaged in a pattern of aggressive stimulus. Stimulus, in simple terms, is the transfer of public wealth to private sector balance sheets. Likewise, the almost certain restructuring of supply chains to encourage reshoring of production away from China is likely to result in income transfers from the emerging markets to the US corporate and household sector.

Here is an interview with Mike Green where he dives more into his research and viewpoint: https://ttmygh.podbean.com/e/teg_0003/

I've selected a few key quotes:

Those under the age of about 40 have an extraordinarily high level of passive ownership and those are the ones that are buying. Those over the age of 65 are the ones that are selling [...] they actually have quite low passive allocations, between 15% and 20% for those over the age of 65. As a result, what we are seeing is discretionary managers being sold and non-discretionary or passive managers being bought. That inflation is extraordinary and exponential in its power.

If you think about the simple math of what happens when you move from a world that is 100% discretionary and discretionary investors carry about 5% cash [...] to a world that is dominated by passive investors that carry on average about 10 basis points of cash.The staggering math that you go through is you realize that moving from a 5% cash holding universe to a 0.1% cash holding universe causes the market to go up 50x."

For an explanation of why large scale passive investing increases volatility and could lead to a market collapse, see here (it's good information despite the clickbaity title and delivery): https://www.youtube.com/watch?v=2Y8k73E1K4A

TLDR: Just the passive inflows are likely enough to continue to propel the stock market into new all time highs, while also increasing volatility. This only works as long as there are still enough active participants in the market to transact with the passive participants, otherwise the whole system will collapse. Passive will likely continue to increase it's market cap and we don't know exactly what passive market cap level is the point of no return.

[Mister Imperceptible]

@white belt

Excellent distillation.

MG has articulated that essentially ZIRP and QE and passive indexing will be pushed to their logical conclusion, which is collapse, because central banks and the investment community do not know what else to do. Of course, kicking the can requires 1) ever more force each time it is required to kick the can, as the can keeps getting heavier, and so we see 2) each time the can is kicked it does not go as far.

[Flurry]

Well, shouldn't there be a balance between passivly and actively funds as soon as the markets become inefficient due to the passive investing and give the active managers the opportunity to exploit these inefficiencies?

[ertyu]

In theory. In practice, all the info by Mike Green above essentially expounds the reasons why this “inefficiency” persists and is likely to continue to persist.