I’m in a forward timezone to New York. But when I sat down this morning to offer up a few thoughts on the global equity rout (while you were hopefully still sleeping despite knowing what futures were doing) it occurred to me that I’d rather share a little history of how I came into the business as well as detail the fact that most market participants, including myself, never know the precise unknowns that are finally gonna get you as an investor (or bull markets for that matter) in the end. This post may not help you make money today, but it could help you lose less in the coming weeks/months. It’s a tad long so bear with me:
From the moment I started at in the business on February 3rd, 1997, to the day that I went off to get married on March 15th, 2000, I was fairly certain about one thing, I had no clue how financial markets collectively worked. My job as a clerk for a trader at a long/short equity hedge fund was to execute orders in stocks that my boss thought were either going to go up or down in the coming minutes/hours and sometimes even days based on technical and momentum indicators.
But during this time I started reading whatever I could get my hands on (Wall Street analyst reports, Barron’s, WSJ, IBD all in print form) about the underlying businesses behind the stock symbols to get a sense for what would catalyze an expected move. In hindsight, arming myself with fundamental information about the stocks that we were trading gave a certain false sense of security. That’s because the biggest and most dramatic moves in any single stocks (aside from a take-over) came from large macro events.
Less than 6 months on the job in 1997, the Asian financial crisis hit U.S. equities. At the time I was not well traveled, could not pick Thailand out on a world map, and until then had no clue what a baht was. It didn’t matter because most around me merely pretended to understand the inner-workings of the global currency markets and how it would affect stocks in the U.S. The devaluations of multiple currencies in far off lands hit U.S. stocks for a bit and caused a lot of fear. And then before you know it we were back off to the races.
A year later things went haywire in Russia. The powers that be devalued the ruble, defaulted on debt and we had another exogenous event roiling our stock markets. This time though it took down a very levered U.S. hedge fund (LTC) run by Wall Street legends and a freaking nobel laureate who contributed heavily to how all of price derivatives to this day. This hit close to home, and those around me seemed a lot more concerned than the crisis of the year prior.
But soon enough in the U.S. we were back to inflating an emerging tech stock bubble without a care in the world. 1999 was an absolute blur. Not having an external financial crisis made things kind of easy, it was a sort of one step back three steps forward for U.S. stocks. The universal bullishness (not withstanding some fairly silly fears about the clocks changing on the millennium) was powering a rally that some market participants thought was the DAWN of the most epic bull market (despite registering 30% gains on average in the S&P 500 from 1995 through 1998) the world would ever see. By early 2000 I was trading my own pad and thought I was the next coming of George Soros. I planned to move to London to start a l/s equity group for an emerging fund, so I cleared out all positions and left to get married with a honeymoon for two weeks. All seemed right with the world.
This of course was not the case for equities and they started to crash. The U.S. stock market’s early 2000 parabolic move was in hindsight a death-rattle. It was soon lights out with three consecutive years of declines averaging 14% from 2000 to 2002.
We thought we were trading/investing in stocks that would trade on their own merits, their earnings potential, or the promise of new life-changing products. External events that briefly crashed the major indices merely gave you buying opportunities. You were a fool to be cynical. But with what was going on in 1999, you should have been.
And obviously in recent years there was another unknown unknown that shook the financial world. It was born of similar hubris (I’ll save the details for another long winded post), but like the dotcom crash, it resulted in a 50% peak to trough decline in the S&P500.
So here we are. Until just a couple weeks ago the U.S. stock market was, despite modest ytd gains the darling of global stock markets (with the strongest underlying economy in the developed world). Last week our markets were down nearly 6% on little to do with anything going on here in the U.S. (don’t even start with the Fed’s impending rate hike) and this morning the rout continues.
While there is still so much that I don’t know about the inner-workings of the financial markets I have been fairly certain for months now (as I’ve repeatedly written) that the volatility in almost every other asset class the world over would eventually reach U.S. stocks. And complacent investors needed to rethink their world view. By no means do I suggest we are about to crash as we did in the spring of 2000, or the second half of 2008, but to dismiss the possibility given the state of the global economy and the uneasiness in global financial markets would not be prudent.
We are in uncharted territory on so many levels and no one knows how investors will react.
So how do we play this renewed volatility?
We look for cheap hedges when we think complacency is at highest:
Trade – QQQ ($111.70) Buy Sept 110 Put for $2
Hypothetical Trade: SPY ($208) Buy Oct 205 / 190 Put Spread for $3
And after sharp declines in prior market leaders look for ways to use elevated options prices to leg into longs:
Volatility in U.S. equities has been non existent for a few years now while the complacency bubble inflated. But our mission with RiskReversal has stayed the same. We try to help regular investors understand the alternative ways they can express their views in the markets. And a major part of that is to detail the uses of equity options to better define risk, enhance yield and make use of leverage in a cost effective way.
With volatility back and the complacency bubble suddenly popped those lessons will be more important than ever.