This Market Creeps Me Out
I remember something my uncle said a couple of Christmases ago that turned out to be very astute. It was 2018 and the market was crashing. We were talking about the carnage on Christmas Day. I was doing my usual “I don’t have a clue what’s going on” routine. He pointed out one positive was that when it got to be January 1st the passive re-balancing funds (funds that adjust the allocation of stocks and bonds every quarter) were going to buy stocks to get their weightings back up.
At the time, I didn’t really clue in to how important this was. But I am wrapping my head around it now. I’ve read all these Mike Green pieces and listened to his past interviews (he’s on RealVision a lot). His themes are mostly centered around passive investing (which re-balancing funds are a part of) and to a lessor extent vol strategies and carry (which I wrote about last post). With respect to passive investing, consider the following:
- Passive investing is 40%+ of the market now
- Passive investing is 100%+ of flows – in other words it represents more than 100% of the new money coming into the market (this is because millennials are almost entirely passive investors
You add carry strategies on top of this (some of which are probably already included in that 40% bucket but others are not) and you can start to paint a picture of what is happening in the market.
Consider that there is no decision making process in passive investing. There is no analysis of valuation, of the future prospects of a business or the economy. As Mike Green points out, the basic rule of these funds is: if new money comes in, buy.
Now add to that the impact of the carry trades (short volatility and others) that I have alluded to in my last post. These strategies aren’t driven by a value assessment of the market either (at least not in a fundamental way).
Carry trades are more like side-bets. They add liquidity and momentum, but they don’t assess value. All they really care about is that their return is there. They just want to clip the coupon.
Add it up and you can imagine how, as these strategies take on more weight, that more of the market becomes driven by forces that simply do not care about reality.
To think about the impact consider this thought experiment that Mike Green makes: assume 100% of the market is passively invested. Now $1 of new money comes into the market. What happens to the market? It hits an asymptote – there is no seller. Passive funds don’t sell because of valuation. The market keeps going up and there is still no seller, unless someone pulls their money out. The opposite applies as well.
Obviously this isn’t realistic but it illustrates the general point of what happens as these factors gain influence.
It’s crazy. But I think it helps explain why some of the market seems to be divorced from what might makes sense right now. And maybe why the market as a whole doesn’t really make sense right now (though as I’ve written about before, I’m not totally sold on that).
For me, I don’t have to map this out 100%. It doesn’t matter if such-and-such nuance is flawed or so-and-so nuance hasn’t been considered. All that matters for my market decisions is to weight the potential that the above assessment is right, and let that weighting influence my buying and selling decisions.
I am definitely putting some weight on the idea. I think that over time this dynamic means higher prices than what we would otherwise have. I think it means momentum continues to do better (though right now, I mean my goodness!). And I think volatility is going to be higher than you’d expect, maybe even as stocks do well.
What it means practically is that I have to take a little off my hedges. Which I did on Friday. But I also took off my longs as well. I just lowered exposure.
Now, you might point out that if I really believed the above, the right thing to do would be to just say F-it, add to longs, dump the index shorts. Stocks only go up right?
But, I am reluctant to do that. I am weighing the option against something else I suspect is going to happen: that while the market may have the inclination to move higher, it will also become more volatile. So I have to be careful about becoming stretched, regardless of what I might believe the eventual direction to be. That 7% correction we had a few weeks ago makes perfect sense in this environment. It might portend to the future – these kind of extremely sharp but short-lived corrections could become the norm. I need to be careful about my exposure to that.
There is weird stuff going on:
Maybe the better way of explaining why I am reducing exposure is simply: this market creeps me out. Like I feel really, really uneasy about it – and not because I think a crash is imminent – it more just feels like the wheels are coming off. I said a couple months ago I could see 4,000 or 2,000 on the S&P. That feeling is as strong as ever right now.
Reminiscences of a Stockblogger 
You are certainly having a good year return wise so far, even given your concerns about the market. I think this will be one of those years where a lot of (especially more aggressive) traders end up giving all their gains back, so it will be important to keep your gains, but at least you have solid gains to keep this year.
Thanks. Like I wrote in the comment my tolerance for volatility right now is pretty low so I may protect gains but I’m unlikely to make them in pace with the market.
This is very smart, and a good way to think about the market. I think the potential dislocation and disconnect it implies will also create/is creating big opportunities, but those will require both patience and fortitude.
I wrote this on the weekend and today I followed up on these comments with even more risk aversion. Its almost embarrassing – in the last couple trading days I’ve reduced my exposure by nearly 40%. I just have no tolerance for risk, or more aptly for volatility. I sensed it coming and so as my portfolio slipped today (I end up down a little over 1%) I just sold.
In retrospect this may seem like folly but I don’t know, I just can’t shake the uneasiness – I guess from the volatility. I’m looking for participation to the upside without the volatility – hah. When the market is moving up I get nervous about my shorts and when the market reverses I get nervous about my longs. I don’t know if I’ve ever felt such uneasiness coming from both sides simultaneously. Usually the feeling is indicative that I’m on the wrong side of the market, but in this (unusual) case I feel equally uneasy both ways. The only thing I can think to do is to find a sweet spot by reducing exposure, so that is what I’m doing. Maybe I’ll get some renewed clarity by doing so.
Also I made the blog private again because it got linked to by some value site and I don’t like that.
I hear you! And it’s definitely easier (though still devilishly difficult) to know yourself than to know the market, so taking down exposure when you’re (extra)nervous is always a good move, because it lets you operate from a position of strength. I’m doing the same–albeit in a more foot-dragging manner–and am hoping for/working toward (though not expecting) more clarity too.
My way of solving it is investing internationally. Hong Kong, Singapore, Japan, Australia, UK, EU, USA, Canada. And focusing heavily on cash flow, fundamentals.
Even with Covid this actually saved my ass. Im up 5% or so this year, despite not hedging (actually lost money on those as I did some panic hedges at wrong time), and despite making a few stupid mistakes.
Generally there is low correlation as various countries are in different economic cycles, so you can always rotate into the cheapest stuff and be close to 100% invested. The best kind of diversification IMO, but you gotta buy cheap enough (because of currency movements) and know the intricacies of the local markets (especially in Asia).
Is not for everyone though. But I come from a small country, so investing locally isn’t really an option anyway.
Interesting how different our styles are though. I could not sleep well with your style, as you seem to be more momentum/sentiment/story driven, and focus less on what a company is earning right now. You seem to do well with it though, so I always read your posts with interest.
I googled “this stock market creeps me Out” and found this article. I feel the same way since about the middle of July. It feels like another ordeal to have to contend with on top of all the other creepy things happening right now. I was in pretty heavily but cashed out 2 weeks ago; the relief is palpable.