It’s the second month of the year already. So, if your New Year Resolutions haven’t taken off as you thought they would, don’t fret. You have another 11 months to get that in order. But if even one of those resolutions had anything to do with jumping into the market when the consolidation is over, the we know how that turned out.
What we thought were early signals of trend resolutions in the last quarter, quickly morphed into prolonged consolidations. With the consolidations playing out as they do, we’re back in a ‘wiggly worm’ market.
But is this playing out across all asset classes? Not entirely. Commodities and Bonds have been pretty clear with their respective chosen directions. Commodities have been showing continued strength and Bonds (true to their intermarket relationship) are heading lower. What does that leave us with? Equities and Currencies of course (DXY taking center stage). Both of which have been a mess. But as every philosopher will tell you, there’s beauty to be found in a mess too! This loosely translates to there being opportunities in a few global equity markets that are faring better than others.
Go through the major world indices and you’ll see certain economies outperforming others. Singapore, South Africa, Czech Republic to name a few, have been displaying strength at a time when several major markets are moving sideways or lower. A good exercise is to go through the world indices on a regular basis to get a bird’s eye view of the prevailing trends. It’ll save you a lot of ‘false alarms’ of the ‘the sky is falling’ chatter. This is because our mind works like the weighted moving average. We tend to give more weight to the factors we think matter most. While that is not an entirely wrong approach, it is not always helpful, or may not paint the most accurate picture. Sometimes a simple moving average is the order of the day! Even if the market is messy and you want out, keep your mind in. Keep following the trends. The best time to learn the market’s idiosyncrasies is when it’s at its messiest! So go down the rabbit hole, it’ll be good I promise!
Until next time, Think Technical!
Rashmi Bhatnagar, CMT
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In last month’s Technically Speaking, we showed the price of downside protection has risen dramatically, with longer-dated, low delta put options experiencing the highest increase.
While the post-pandemic environment is historically unique, how does it compare to the 2008 Financial Crisis and 2018 trade war sell-offs? What can those examples teach us about the duration of inflated protection pricing?
How long does it take for pricing to normalize after a spike in volatility?
Duration of Pricing Spikes
To answer this question, we looked at spikes in out-of-the-money SPX put option pricing during the Financial Crisis, 2016, and 2018.
We calculated the mid-price for the contract that best fit our criteria (.05 delta puts with 60 days to expiration) each day at 3:45 PM EST. We evaluated all expiration types, tracking the contract that best matched our defined DTE and delta, regardless of weekly, monthly, or quarterly expiration.
To visualize the duration of the spikes, we calculated the 60-day average contract cost before the pricing increases. The blue horizontal line shows the average in each plot.
We defined “normalize” as when the pricing scatter plot fell below that 60-day average line for multiple trading days. As you will see in the plots, this did not always happen.
SPX Put Pricing: Financial Crisis
Figure 1 shows protection puts had a historic price spike in late 2008, the largest on record before the Pandemic Crash in 2020.
However, the scale of Figure 1 prevents us from seeing the pricing fluctuations produced by the volatility of the Financial Crisis.
In Figure 2, we plotted the same data as in the previous figure but removed the 11 high-magnitude data points from Figure 1. This lowered the left y-axis scale from 1-100 to 1-10. The pre-event 60-day average and VIX values are unchanged. On this updated scale, it’s easier to see that pricing did not truly mean-revert for nearly six months.
SPX Put Pricing: 2015-2016
In 2015, protection pricing rose as the market entered correction territory. Prices slowly reverted to their mean following the initial spike. While they did fall below the 60-day average about two months after the initial pricing increase, contract prices did not persist below that level until April 2016, nearly eight months after the initial price increase.
SPX Put Pricing: 2018
2018 offers a unique look at the duration of elevated put pricing. Starting in February with inflation fears and ending with volatility due to the onset of the China-USA trade war, put protection pricing remained elevated for the entire year.
It is interesting to note that throughout 2019, leading up to the Pandemic Crash, put protection prices never reverted to their previous level.
These historical examples bring us back to our current focus. The Pandemic Crash elevated put pricing beyond its already historically high levels.
Looking back through the charts, this pricing level relative to the VIX would have been unimaginable during previous volatility events. Protection pricing has fallen some since the Pandemic Crash but is still well above the already-elevated previous levels.
The magnitude and duration of protection put pricing is largely unpredictable. The price to protect your portfolio with OTM puts has still not mean-reverted since the 2018 increase. The volatility from the Pandemic Crash has taken these prices to another level despite new ATHs throughout the second half of 2020 and 2021.
Tying It All Together
The past does not give a reliable indication of how long this pricing will persist or if it will mean revert, but we do know that traders are preparing for the “unknown unknown” by prioritizing downside protection.
Since the Pandemic Crash, hedge pricing has dramatically risen, with longer-dated options experiencing the highest increase.
After a market correction or significant spike in volatility, hedging is on many investors’ minds. With the pain of the last portfolio decline still fresh, traders line up for portfolio protection in hopes of preventing it from happening again.
As markets settle down and volatility subsides, investors tire of paying premiums for portfolio protection and demand subsides, causing put prices to decline. Then, when a volatility event happens again, the unhedged are exposed yet again, and the cycle repeats.
The price of portfolio protection ebbs and flows. When protection pricing is high, perhaps pursue alternative hedging strategies. When it is low, don’t get lulled into complacency and skip out on protecting your downside.
In Part I, I provided a simple approach to integrate technical and fundamental analysis. This is essential because most fundamental analysts have a disproportionate bias to the upside. In many respects, it is understandable because fundamental analysts follow particular companies continuously and there is no reason to do so if the performance of a company will not improve over the next twelve month period. Additionally, there is an inherent nature to believe that the future will be better than today. What is more, the market indices are designed to go up over time since laggards are replaced without restatement. Such logic is difficult for a CPA to fathom.
For example, the S&P 500 spot compared with the median target price from December 2022 through November 5, 2021 is shown in Exhibit 1. Over this period, the index was reconstituted with new leaders added and laggards replaced, and despite several major pullbacks, including The Great Recession and The COVID-19 Recession, the forward S&P forecasts were always higher, with an average 250 point spread between the spot and forward median target price.
Exhibit 1: Consensus Suggests Fundamental Analysts are Naturally Bullish
At the time of this writing (early November 2021), the market is at all-time highs. The first of Ned Davis’ nine rules “don’t fight the tape” along with broad-based participation does not give any technical indication that the current uptrend is in jeopardy. Therefore, when looking at the individual companies included in several well-known indices, it is not surprising to expect an overwhelming consensus of buy/hold ratings as set forth in Exhibit 2.
Exhibit 2: Consensus Suggests Underlying Companies’ Fundamentals are Strong
Source: FactSet as of November 7, 2021
Euphoria does not last forever and eventually this bull market will end. The question is will fundamental analysts recognize the macro change when it does occur? There is a recent real world example that suggests the answer to that question is no.
From the January 3, 2020 closing high of WTI Crude Oil to its closing low on April 27, 2020, WTI dropped 79.7% and the XLE fell 41.4%. The energy stocks included in the S&P 500, the S&P Mid Cap 400, and the S&P Small Cap 600 indices during the aforesaid period (see Exhibit 3) remained an overwhelming consensus buy, despite many analysts forecasting WTI oil prices to remain below $70 per barrel through 2026. Even today as WTI consensus is at $68.73 and $67.55 for December 2022 and 2023, respectively, and the commodity trading above $80.00, it seems odd to be overly bullish on energy names while bearish on the underlying commodity which has had a 0.76 correlation to XLE over the past 20 years.
Exhibit 3: Energy Sentiment Remained Bullish when Macro Fundamentals Collapsed
Source: FactSet as of November 7, 2021
Before I am accused of unfairly picking on energy – after all, nobody could have anticipated the demand destruction of COVID-19 – I looked at analyst ratings of all companies underlying today’s S&P 500 Index as of October 9, 2007 (the index’s closing high immediately before The Great Recession). At that time, there were 304 sell ratings across 6,631 analyst ratings or ~4.6%. On March 9, 2009, (the index’s closing low during The Great Recession), there were 577 sell ratings across 6,879 analyst ratings or ~8.4%. While there may be cases in which valuations are skewed, if markets are even close to being efficient, it should not be this widespread, especially in a post Regulation FD world which has persisted for over 20 years.
After staying relatively range bound from $75 – $115 from December 2010 – November 2014, WTI broke support and ultimately fell to 63% from November 14, 2014 to February 9, 2016 versus the S&P 500’s decline of 9%. WTI eventually bottomed in February 2016 and subsequently rose to $73 in September 2018 before staying range bound between $65 – $50 until February 2020 and the COVID-19 demand destruction (see Exhibit 4). Despite the structural shift in domestic production due to the shale revolution, fundamental analysts remained bullish on energy stocks (see Exhibit 5).
Exhibit 4: WTI Monthly Chart
Source: StockCharts.com as of November 7, 2021
Exhibit 5: Energy Sentiment from 2014 – 2020 when Macro Fundamentals Deteriorated
Source: FactSet as of November 7, 2021
I often remind people that there is much more to technical analysis than lines on a price chart. While this is an important part of technical analysis, modern technical analysis also includes risk management, statistical analysis, security screening, and understanding human psychology. These very important categories usually are ignored in fundamental analysis. A great story does not matter if no one else is buying the stock.
Exhibit 6 is an illustrative example of First Trust Global Wind Energy ETF (NYSE: FAN). Despite a federal administration that was pro-fossil fuels, FAN broke to new highs in mid-2020 and continued its ascent rising 62.3% from July – December 2021 versus the S&P’s rise of 20.5%. However, when a pro-renewables administration entered last January, as well as substantial investments in wind projects both domestically and abroad, FAN has spent the majority of 2021 in a trading range. This example demonstrates that despite favorable fundamentals due to the bullish prospects of renewable energy, particularly wind, by federal and state governments, prominent political and business leaders, and Wall Street firms, technical analysis could have provided greater alpha by exiting a long position when there was a confirmed trend changed (and either shorting FAN or finding another opportunity), trading the range, or passing all together until FAN’s price breaks out of its range. The opportunity cost of staying in a sideways trade for months often is overlooked and may not be the best use of capital.
Exhibit 6: Technicals Navigate 2020-21 better than the Macro Environment
Source: StockCharts.com as of November 7, 2021
The integration of technical and fundamental analysis results in actionable ideas beyond buying or holding for the next twelve months or selling a position today. The goal of an investment is simple – make money. While investing in companies with strong fundamentals has a long history of success, if positive returns are not occurring, a fresh analysis using different tools should not be dismissed. The time value of money or opportunity cost is seemingly often overlooked when in an underperforming investment. Being tactical, with at least a portion of the portfolio, can drive greater returns.
The case to integrate technical analysis with fundamental sell-side research is simple:
- Enables a holistic approach to the market
- Provides a real-time understanding of the market environment
- Looks at price/executed orders and not assumptions
- Facilitates efficient timing in position entries/exits
- Allows for strategic hedging to maximize alpha and reduce a portfolio’s volatility
- Enables the sell-side firm to offer a proprietary and differentiated product
- Helps drive increased client votes
Simply stated, technical analysis helps to identify when an action should be taken and when to simply “ride the wave” as opposed to discrete buy, hold, or sell decisions as of a moment in time.
Accounting and chart analysis clearly require different skillsets, but many of the core tenets that make for a good CPA also make for a good market technician. As a result, while there are few CPA – CMTs, in time, the combination may be more common, especially as more buy- and sell-side firms look to hire CPAs to assist in their fundamental analysis. For the time being, I will relish being one of the few to have both designations and continue working with friends, colleagues, and clients to better understand the value in pairing the two disciplines.
When not skiing Lake Louise or surfing off the California coast, this month’s guest is helping investors catch the next big wave in the markets. For our listeners not already familiar, Mebane Faber, CMT is the:
- Author of 5 books and editor of 2 compilations
- Creator of the Idea Farm – a market research library
- Host of the Meb Faber Show, one of the most widely received podcasts on financial topics
- Scores of white papers
- and hundreds of blog posts
As the co-founder and the Chief Investment Officer of Cambria Investment Management, Faber is the manager of Cambria’s ETFs and separate accounts. This month’s discussion covers all the tools and process that drive the investment practice of Cambria including, the guiding pillars of value and momentum. Known for advocating for diversified, multi-asset portfolios, this interview tugs at the challenges of global investing and the home bias that has worked to the advantage of American investors during the past decade. As regimes shift however, leadership may shift again to ex-US equity markets and alternative assets within the commodities space.
Mr. Faber graduated from the University of Virginia with a double major in Engineering Science and Biology. This background undeniably shaped his investing practice with a firm grounding in the scientific method. Meb is an ardent researcher exploring the persistent anomalies of the market and continuing to discover and explore the nuances of multiple strategies in practice.
Enjoy episode #14 with our special guest Meb Faber, CMT
New Educational Content This Month
June 29, 2022
The Institutional Use of Technical Strategies
Presenter(s): Brennan Basnicki, CFA, CMT
June 15, 2022
How You Can Benefit from Little Known Seasonal and Cyclical Patterns
Presenter(s): Dimitri Speck
May 11, 2022
Clearing Away the Clutter
Presenter(s): Greg Schnell, CMT, MFTA