What If?

Romain/ septembre 14, 2020/ Finance/ 0 comments

I got it.

The US stock market cannot drop because Donald trump does not want a crash before the election. Besides, the Fed will intervene if necessary, and ZIRP means that there is no alternative to stocks. Last but not least, any correction would lead to even more aggressive purchases by retail investors. So, we are safe now!

The thing is, almost everyone agrees on this. Everyone shares the same thinking today, as most bears have capitulated.

So, what if the real source of risk was this ultra-bullishness on stocks?

I have already cited econophysics research works, explaining that capital markets exhibit a sort of macro-behavior at the peak of a speculative bubble. This is what we are seeing today, and such a pattern suggests that a crash is imminent.

As any bubble, this one has had a self-reinforcing narrative for years, and finally price variations have become the main reason for further upside. Haven’t Wall Street analysts just raised target prices because of TINA and FOMO?

While the retail army has rushed to buy even more calls on tech names, what if the Nasdaq fails to make new highs soon? And what if market makers start to reverse their hedging strategy, selling a huge volume of stocks or equity indices?

This might be purely theoretical, but because people tend to underestimate fait-tail risks, you should expect a massive spike of equity puts if this happens.

I have already explained that the main sources of financial stress lie in hidden risks, in opposition to obvious risks (see The Great Wall and the Big Short). Names like Tesla, Nikola, or Virgin Galactic are obvious risks as many people expect those company to fail sooner or later, while what is going on with big tech stocks is a hidden risk.

Somehow, Tesla is the equivalent of BB tranches of CDOs in 2008, while the Nasdaq index is the equivalent of AAA tranches. The biggest problem came from AAA tranches as most investors regarded them as “risk-free”. In other words, the volatility spike would be much bigger for big tech stocks than for controversial companies.

Beyond the FAANGs and large cap indices, another source of risk lies in the ETF market. One should remember that there are more ETFs in the world today than all the listed companies in the US, and I have already warned on this growing concentration risk (see To Be Passive Is to Let Others Decide for You).

Thus, what if everyone starts to sell the same mega-cap shares at the same time? Is there any risk of ETF dislocation?

One last thing. Imagine Robinhood traders’ reaction if equity puts started to soar. Remember that those participants love to chase the outperforming instruments of the moment. Would they rush to buy puts?

If yes, it would push puts prices even higher, and it would create an opposite gamma squeeze, leading market makers to sell even more.

Of course, there might be too many “if” in this post. After all, we all know that “stocks only go up” and that the Fed has our backs. And this is why most people chose to take the blue pill, isn’t it?

But you’d better be sure that you fully understand the risk of each instrument trading close to all-time high. And remember what Warren Buffet says: “the stock market is a device for transferring money from the impatient to the patient.”

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