Being wrong about the direction of a stock, or a market is part of this business. What I have found in my nearly two decades trading in financial markets is that embracing the fact that you will be wrong (in some periods more frequently than you will like) is the only way you can eventually be right. It comes down to risk management. For the better part of 2016 the S&P 500 (SPX) struggled to make a new all time high. I was close to convinced that such an event was not likely to happen for a whole host of reasons (detailed daily in this space) but if it did it would be significant. In early July the index finally broke out:
I was very wrong. The thesis was that the inability to make a new high amidst a global economic slowdown was signalling an upcoming period of downward volatility rather than a consolidation before new highs. That thesis dictated some of the trade ideas detailed on these pages which ultimately were proven wrong. Upon the realization of being wrong on the macro trades (that also informed some of my micro trading) there is only one course of action, cut losses, and trade less frequently (and in smaller size) until you can create a new course of action. This is what some risk managers call the four step trading rehabilitation program. 1. Recognize you have a problem, 2. Stop the Bleeding, 3, Reset trading perimeters and lastly 4. Get back on the horse.
August was a slow month with little to see in the markets so I am somewhat still in stage 3. The price action in the SPX since the July breakout between 2140 and 2190 isn’t telling us a lot:
So what to do? To state the obvious, the Federal Reserve holds the key prior to the Presidential election in early November. If the Fed were to surprise with a Fed Funds rate increase on Sept 21st at their next meeting (this is unlikely, currently Fed Fund Futures predict only a 20% probability of a raise) then we would certainly get a break of this consolidation, to the downside. 20% probability two weeks out might as well be a zero probability (remembering, Goldman Sachs research in May found that going back to 1994, 90 percent of the 31 rate hikes were priced in at least 50 percent 30 days ahead of the FOMC meeting).
Where else to look for signs? Interest rates don’t go higher (the yield on the 10 year Treasury bond seems pinned to 1.5%), money is pouring back into high priced growth stocks (Amazon and Facebook closed yesterday at all time highs) and high yielding sectors like Utilities and Telcos have once again caught a bid. We are kind of back to the 2015 playback with crowding into a handful of sectors, some antithetical to growth, and a few dozen stocks whose current growth (for now) justify lofty valuations. I think it is important to note that in 2015/early 2016 I found this set up in U.S. stocks troubling. On a couple occasions I was right, when too many investors headed for the door at the same time, the dislocations were massive with two very sharp draw-downs, but the subsequent V reversals, which have ultimately led to new highs and now a period of historic calm in the SPX have ultimately proven most market views wrong.
If the Fed were to surprise in two weeks, Sept 23rd weekly options in the SPY (the etf that tracks the SPX) are cheap in volatility terms, with 30 day at the money implied volatility at 9.25% (blue below), despite realized volatility (white below) being at all time lows at 5%:
This is an example where the options market has a difficult time in pricing in the unlikely (tail risk). The Fed funds futures have a 20% chance of a move in September. Without knowing exactly what a market reaction to that low probability event would be, rather than try to price in that 20% chance of the unknown, the options market merely ignores it.
But that can be good for hedging and directional bets. The SPY at the money straddle, expiring Sept 23rd is pricing in just a 1.8% move between now and then. That includes the Fed meeting and means the historically cheap volatility from a historically slow August is still available. It probably won’t last.