If you just turn on your TV or computer and check how the big stock indices are doing, things have been pretty calm and steady. Under the hood, though, there are a lot of pent-up issues, starting with the myriad follow-on consequences in the financial markets from a decade of Fed interest rate manipulations. At some point that underlying turbulence should become hard to ignore. I want to talk through my investment roadmap for these times, from the short term to the long term. There is a tremendous array of important and potentially interesting details we could get lost in during this journey, but in the interest of keeping this blog short and sweet, I’m hoping to keep my commentary fairly simple and basic, focused on the most likely concerns.
It’s always hard to forecast the short term. (Whether the Pittsburgh Pirates will win their next baseball game is anyone’s guess; but the probabilities are much clearer for whether they will win the next World Series.) Depending on who talks to whom, or what company X says on their next quarterly call, your short-term judgment can get altered. But away from the short-term noise, you can look for patterns. For at least the last year, we’ve had a market where the booming options trading ‘tail’ has been wagging the stock market ‘dog.’ What happens in options has had an outsize effect in the market.
For the last many months, stock market volatility has trended lower, which really reduces the cost of buying put or call options on individual stocks or on broad market indexes. This, in turn, creates an increasingly aggressive bid in the options market leading to smaller drawdowns. Would it surprise you if eventually that system tends to break as more people pile into the speculative options game?
According to SpotGamma.com, we’ve finally hit a point where short-dated implied stock market volatility is back to pre-crash (February 2020) levels. That means traders are expecting little risk volatility in the near term. What if they’re wrong and the options they’ve sold are “in the money?” They’ve effectively been picking up nickels in front of a bulldozer, and at some point, instead of picking up a nickel, they lose a buck (or $20) as the dynamics that drove the market melt-up reverse sharply to the downside.
Could this happen as soon as this week as options expire on September 17? Nobody knows, but the conditions are in place as the volume of stock options sold for nickels continues to grow.
Panning the lens out a bit for a wider-angle view, we can see that there are a number of potentially significant underlying concerns that could create options and market risks, including consumer inflation, profit margins, QE taper talk, Fed meeting guidance, Congressional debt ceiling negotiations, Covid-era stimulus fading, new stimulus negotiations, and more. There are a lot of variables to alter the current pattern of smaller and smaller stock market drawdowns.
I acknowledge that, even in the best of times, there’s always something to worry about. While the pace of stimulus and money growth has slowed, is that enough to dent the Fed-encouraged animal spirits that have dominated financial markets for so long? I honestly don’t know. I can easily create a scenario where we can continue the grind higher for another month or two. Again, I think the short-term is the hardest part of the future to call in all this.
Let’s say we have a ‘surprising’ downturn, which at this point could be as little as a 2%-4% move. What then? Maybe there’s sufficient liquidity and positive sentiment that the dip gets bought. Or maybe dealers removing hedges helps crash a fragile market and we head down to the 200DMA or even lower to 4,000 (down 10%-12%) on the S&P 500 Index, where there’s a lot of options support. Maybe somewhere in the middle. It’s really hard to say. It looks like the market is sort of at a ‘pause point’ right now where a lot of economic data isn’t really accelerating or decelerating, where we’re waiting for decisions on stimulus, a new slate of earnings announcements, and so on.
I think we’ve seen that in the market of late, where not a great deal has happened with economic data and trading volumes are low. What happens in this interregnum period while we wait for direction? A lot of things could happen, in my mind, and it may become clearer with just a bit more time and data.
More important to building durable wealth, can we say what happens after this pause? I think so. Growth is clearly slowing, to an extent that its impact on corporate earnings is pretty unavoidable. You can choose not to care about weak economic data, but historically growth matters quite a lot to the stock market over the long-term. I believe we generally will want to tilt toward stocks that do well in slowing environments, like defensive (e.g., selected utilities, consumer staples, health care), quality, and precious metals stocks. (This is not to exclude other sensibly priced current opportunities, such as selected cannabis stocks.) Our portfolio tilts may not work right now, they may not even work next month, but their time is pretty clearly coming. And let’s face it, if you look at a lot of those kind of safer names, including Treasuries (TLT) and Low Volatility (SPLV,) it’s been a fairly pleasant ride the past several months. But in the evolving future, a lot of what has been working with the popular stocks is likely going to stop working. We should expect a rotation, and to me it’s largely a question of how long before it becomes obvious.
I also think it’s worth talking about the very long term, the next several years. Ultimately, something’s got to give. Is there a path to a market permanently making 15% a year when GDP growth is 3%? Not really. Maybe with hyperinflation we could keep the game going for a bit but that’s both unlikely and unpleasant. More likely this huge multiyear surge has borrowed returns from future years. That doesn’t mean the whole market has to crash, just that you have to be careful. Like in 2000, the market has created some spectacularly aggressive valuations with some companies. And like in 2000, it is probable that some people are going to end up paying the price. The most important thing to building durable wealth, in my mind, is to avoid being those people. Risk management and risk mitigation really matter in long-term investing. Maybe people can play the “chasing-hoped-for-future-rewards” game a while longer, but eventually you want to only be owning companies who can justify their price with a stream of cash flows. Managing the big events over the long-term has always mattered greatly in successful investing.
While that long-term view is important, you might want to know what do we do right now? Right now is tough. Some things, like mega-cap tech, have performed very well for a long time. This has effectively made them bond substitutes for some people, but is that forever? Can that change soon? Similarly, investors are, broadly, as fully invested as they’ve ever been, but there’s also a fair amount of hedging, such as with index options. Will the hedging stop any significant decline, or will actual de-risking (selling of underlying positions) win out? Right now, it’s hard to say, but longer term, some recognition of potential problems is at least something to consider.