The Myth Of Controlled Market Demolitions

If you take your cues from the pantheon of market “legends” who appear weekly in the financial media, often to deride the current monetary-fiscal policy conjuncture in rhapsodic terms, it’s all going to implode imminently. Stocks, credit, bonds — all of it.

“Checking all the necessary boxes of a speculative peak, the US market was entitled historically to start unraveling any time after January this year,” Jeremy Grantham told Bloomberg, during an extended Q&A late last month.

Asked what he would do if he were Fed Chair, Grantham claimed, without so much as a polite nod to the gracelessness inherent in Monday morning quarterbacking, that he would have prevented both the dot-com collapse and the Global Financial Crisis. “I would have moved to curtail US stocks in 1998-1999 and housing in 2005-2007,” he said.

That was on June 22. The S&P hit a record high in every session since (figure below).

Friday was the seventh consecutive session of records. That hasn’t happened since 1997 (when, in a parallel universe, Fed Chair Grantham was busy averting the tech blowup.)

As Bloomberg’s Lu Wang wrote in the course of documenting the US benchmark’s run of records, the uptick in the unemployment rate that accompanied June’s otherwise robust jobs report “helped bolster views that the Fed won’t rush to tighten monetary policy any time soon and risk stifling the economic recovery from the pandemic.”

It does all turn on the Fed, but in the meantime, the problem with putting too much stock (figuratively or literally) into the pronouncements and various musings of “name brands” is that those musings lack any semblance of nuance and almost universally fail to mention the dynamics that govern modern markets on a daily basis.

Most of those dynamics don’t care whether, based on some bubble checklist Jeremy Grantham devised, equities are “entitled historically” to crash. Stocks aren’t things that have a sense of purpose — they’re not self-aware. They go where we, collectively, decide to push them and “we” includes systematic strategies and unemotional flows dictated, in one way or another, by volatility.

“Market behavior is showing us that short vol / carry / roll remain the order of the day until ‘new’ Fed guidance comes off the back of additional economic data releases,” Nomura’s Charlie McElligott said, reiterating that after a fleeting spike post-June FOMC, “‘rich vols’ were sold into submission from both systematic- and discretionary- investors full-throttle.”

With one-month realized at ~9 and three-month below 11 (figure above), Nomura’s model estimates the vol control universe accumulated almost $75 billion of new US equities exposure over three months and $10.5 billion in two days to Friday. 

Meanwhile, VIX ETN net vega “has been a one-way purge” (as Charlie put it) since the beginning of the year. The aggregate long position there has been cut nearly in half from post-COVID peaks, while vol selling and overwriting “has led to some pretty epic ‘Long Gamma’ for dealers,” McElligott added.

Thanks to what he described as “insanely compressed volatility and price- / trend- stability,” Nomura’s CTA model shows aggregate portfolio gross exposure in the 94.9%ile.

This is what matters (or a big part of what matters, anyway) on a daily basis.

The risk is always the same. These dynamics are “stability breeds instability” in action, if you will. But you need a spark — some macro catalyst that serves as the proverbial “skier’s scream” which triggers an avalanche.

“Ultimately, this is how over-positioning (via leverage accumulation) ‘tips over,'” McElligott went on to say. “Volatility is your exposure toggle in the post-GFC, negative convexity market structure, but you need a macro-shock catalyst.”

For many market participants, the spark could be an accelerated timetable on Fed tightening in the event the data (with an emphasis on the jobs numbers) starts materially overshooting as labor market frictions abate.

In the same Q&A with Bloomberg, Grantham said that “the Fed since Volcker has been pretty clueless and remains so,” perpetuating the (debatable) notion that Volcker was some kind of hero, whose praises the minstrels will forever sing. “What has been more remarkable, though, is the persistent confidence shown toward all of these four Fed bosses despite the demonstrable ineptness in dealing with asset bubbles,” Grantham went on to chide.

I’ve said it before and I’ll say it again: It’s easy to claim that if only you were in charge, you’d flawlessly coordinate a controlled demolition of various bubbles, surgically remove pockets of speculative excess and reset the economy, thereby putting everything (and everyone) on a more solid foundation.

But executing such a plan is fraught with peril, especially if you don’t appreciate how quickly modern market structure can turn a “healthy” correction into a self-feeding nightmare. The idea of a cathartic selloff orchestrated by a “competent” Fed is nice in theory. In reality, it would likely be a disaster.