Moral hazard squared

 

The challenge with a market propped up on the promise of policy and divorced from fundamentals is it leaves investors with low conviction. Many get forced into chasing the trend against their better judgement and slowly succumb to reflexivity (believing the market is correctly forecasting a rapid recovery). As a result, markets can become comfortably numb, exhibiting much lower volatility than either the fickle sentiment or the still uncertain fundamentals warrant and this leaves them highly susceptible to flash-crashes and tantrums. As we have noted, low vol bubbles directly lead to high fragility.

 

This has been the story of the post-GFC era as central banks have taken control, driving a four-fold increase in fragility events in the last 10 years vs. the prior 100. Covid has only accentuated this trend. Despite the largest economic shock since the great depression and near record earnings uncertainty, the S&P has recorded its fastest rebound since the depression, and volatility is falling near its fastest pace in its 92yr history. Last Thursday's S&P drop (-5.9%) was the 25th largest shock relative to its trailing vol in the 23,224 trading days since 1929 (0.01%-tile), in part fuelled by trigger-happy investors chasing the market with call options that automatically de-lever as the market declines. Remarkably, this historic air-gap occurred from a higher vol level than most, with only the Oct-87 and Oct-97 crashes starting from higher risk levels.

 

This should serve as a reminder that markets are riskier than they appear. To many, it will seem like a great buy-the-dip opportunity, but the risk is that it's only re-loading the spring for the next fragility event and the potential for a more major trend reversal. Fortunately fragility can be hedged. The W trade we introduced in our 2020 year ahead is but one example of a low carry, highly convex hedge that continues to protect effectively against these risks.

 

Highlights from the rest of the globe

 

1. The 'W trade' (short SPX 3m 1x3 put ratios + 1x2 call ratios, delta-hedged) fared well in last week's outsized fragility shock amplified by option technicals

2. Screening for value in hedges for the risk of a second wave

3. Cheapest tail hedges in Rates and FX; In equities, HSCEI puts screen cheapest despite concerns of another wave of Chinese COVID-19 infections

4. ESTX50 long-dated vols muted at current market levels, prefer short put ratios 

5. Value vs momentum reversal last week was more a correlated risk asset selloff than a factor rotation as in Sep-19

6. Best value equity hedges currently in Asia. HSCEI Sep-20 8,000/9,000/10,500 put spread collars for $85 offer a max payout ratio of 12-to-1

7. Asia autocall issuance down 80-90% from Feb highs and will unlikely resume in earnest unless the rally resumes - Expect limited vol supply in the back-end for now