Q3 2019: “Managing Short Side Beta in an Extraordinary Environment”
A fair question: “Doug, could you have moved out of the index to try to capture some of the underperformance in the broader market?” The short answer we could have but chose not to because of the ongoing extraordinary high-risk market backdrop.
There were major uncertainties associated with ongoing trade negotiations, while the Fed and global central banks were pushing monetary stimulus. I continued to see a highly unstable environment with quite elevated risk of abrupt market rallies, intense short squeezes and violent rotations – exactly the type of trading dynamics that make market topping processes such a challenge.
In such environments, it is fundamental to our risk management philosophy and discipline to diligently manage short portfolio “beta” – or the expected losses that would be suffered under different market scenarios. For example, in the event of bullish market developments – such as a positive trade deal headline or tweet – what would be the expected scope of losses in, say, a rapid 5% market advance.
I hold the view that the market has been engaged in a prolonged market topping dynamic. Market tops by their nature are periods of major uncertainties and instability. There tends to be heavy shorting, hedging and derivatives activities – ensuring an environment susceptible to unpredictable market swings, with occasional rapid declines along with abrupt market rallies. Sudden intense short squeezes present a major risk.
In this regard, last week’s market activity was instructive. Positive headlines led to Thursday and Friday’s rally. During those two sessions, the S&P500 gained 1.75%. One of our competitors lost 3.7% during those two sessions, and a second lost 3.11%. The three competitor funds lost on average 2.89% - or 165% of the S&P500’s gain. On average, these three funds effectively posted a so-called “beta” of negative 1.65.
In an environment where I fully anticipate unpredictable rallies and short squeezes, it is imperative to position short exposure to ensure reasonable confidence in our expected portfolio “beta” – where I have acceptable clarity in our potential loss risk parameters. I definitely don’t want to put investors in a position to lose more than twice the S&P’s gain, as one of the short funds did late last week.
And while short stocks in general underperformed the market during Q3, there was a notable short squeeze later on in the quarter. Stocks rallied abruptly beginning on August 28th after President Trump announced the restart of U.S/China trade negotiations. In ten sessions, the S&P500 gained 4.69%. During this period, one of our competitors lost 13.21%, and a second dropped 9.65%. The three competitor funds lost on average 9.76% - or 208% of the S&P500’s gain. As such, on average over this period, these three funds experienced a “beta” of negative 2.08.
Regarding beta- volatility less than, equal to, or greater than the markets.. We titled the call today “managing short side beta in an extraordinary environment”. Expand on the upside beta problem. Over the years, I’ve focused a lot on this “upside beta problem” – where short positions tend to outperform the general market, while individual positions turn highly correlated. What might have appeared a well-diversified short portfolio can rather suddenly become a single highly-volatile bet against a rapidly rising market.
Over brief periods, it is not unusual for short portfolios to have “upside betas” of 2 or, on occasion, even three or higher. Over that ten-day rally, one of our competitor funds experienced a beta of almost negative three – and a second was above negative 2. Over this ten-session period, the Goldman Sachs Most Short index gained 13.94% - demonstrating an “upside beta” of 3.0.
On average during that rally, the three competitor funds lost twice as much as the S&P500’s gain. In an environment that we fully expect to be highly uncertain and volatile, with abrupt rallies and intense short squeezes, I don’t want to position short exposure where the probability is high for losing multiples of the S&P’s gain during rallies. I’m instead willing to miss opportunities to ensure we don’t suffer outsized losses.
So why did I stick with the somewhat outperforming S&P500 short? An important consideration was the extraordinary backdrop that dictated we remain highly disciplined – adhering to well-defined risk parameters. In highly uncertain environments, especially when we’ve suffered losses, my risk management discipline dictates that we “err on the side of caution.” Such a discipline demands adhering to a low beta strategy, not attempting to pick a market top, avoiding trading an unstable market, staying well clear of short squeezes and, in general, remaining patient.
My experience informs me that things tend to unfold much more slowly than one would expect. There are environments to be more opportunistic and environments that beckon for “erring on the side of caution.” In my view – and this is where we differ from others – this has been a period to employ well-defined risk parameters. If we ran a higher beta – a riskier, higher volatility short portfolio, that would ensure significantly larger losses during rallies.
One of the challenges of shorting – which contrasts with long investing – is that your positions move opposite to the value of your account. For example, when the market rises – when short positions are going against me – my short positions grow larger at the same time that losses reduce the asset value of the short account. Let’s use a hypothetical example: Say I have a $100,000 account with a $100,000 short position – so my account would be 100% short. If the stock market rallies 2% - the short position would increase to $102,000, while account value would decline by $2,000 – or 2% - to $98,000. In this example, after a 2% market gain the account would become 104% short – the $102,000 short position divided by $98,000 account value. And if the rally continues the account becomes only more heavily short.
On the flip side, a 2% market decline would see the short position decline to $98,000, while account value would gain to $102,000 – with the account’s short position dropping to 96% - 98/102. On the short side, when the market is rising the short account is becoming more short, while the account becomes less short when the market is declining.
This dynamic makes disciplined active management absolutely essential on the short side. For the most part, I would prefer not to get increasingly short when the market is going against me - and I’m not happy to be less short when the market is going my way.
We have to manage around this challenge. For starters, we set a short exposure target – and then rebalance exposure to stay near our target. This means that we can become incremental buyers when the market is rising – as well as incremental sellers in declining markets. In the above example, if account value drops from $100,000 to $98,000 – and our short exposure target remains at 100% - we would buy back a small amount of our short position to reduce short exposure to target at $98,000. If the market declined 2%, we would increase our short position to $102,000 to get back to the 100% target.
We have maintained short exposure considerably below 100% to help mitigate this rebalancing effort. Short exposure of 65% in the S&P500 - a beta of negative 0.65 – entails less risk of losses, along with reduced rebalance buying into a rising market. High-beta short exposure during rallies creates a major predicament – the manager must either buy back significant amounts of stock to maintain an exposure target – or let short exposure mount and hope for a market reversal.
I have a cardinal rule when it comes to managing short exposure: Avoid Outsized Losses. So, I am no fan of the strategy of letting short exposure rise significantly when the market is advancing. That’s a game of Russian Roulette that I don’t want to play. One of our competitors experienced y-t-d losses as high as 26% and another 23%. Those are the types of losses that can mount in a volatile environment when managing short exposure becomes quite a challenge.
When we anticipate major uncertainties and resulting highly volatile markets – as we’ve experienced both with trade negotiations and monetary policy –- we will generally prefer lower beta for our short portfolio. Others focus on potential opportunities that arise with market volatility - and gravitate to higher beta. We focus first on risk, second on reward. Upside volatility means bigger losses that for us would dictate risk control measures – the reversal of short positions – into market spikes. And we really want to minimize the risk of buying back large amounts of our short positions into spikes – as this negatively impacts performance.
Most short products take a different approach to risk control, remaining fully short even during rallies, squeezes and unfavorable backdrops. This does make managing short exposure a lot easier, while opening the door to large cumulative losses. For us, such losses would be unacceptable.
Fundamentally, I have been content to be short an index significantly exposed to global economic weakness and other risks, and less excited to bet against the U.S. economy. I hesitate to short some sectors – including the small caps – when financial conditions are loose or loosening. As it turned out, junk bonds underperformed investment-grade credit during the quarter – with concerns at the fringe of finance weighing somewhat on the small caps. I also believe being long the small caps against a short in the S&P500 was one of the popular “pairs trades” that stumbled during Q3.
The bottom line remains that this is an extraordinarily challenging environment. I’ve been managing short exposure going back to 1990. I’ve operated in long bull cycles as well as bear markets – I’ve experienced my share of really tough market backdrops. But I’ve never had to navigate through presidential tweets, a U.S./China trade war, or such aggressive monetary stimulus in a non-crisis backdrop. The unemployment rate is today at a 50-year low, the economy is growing at about a 3% pace, financial conditions remain quite loose, markets are near all-time highs – and yet the Fed is about to cut rates a third time in three months.
I am fond of saying that things turn crazy at the end of cycles – and really crazy during the late-phase of historic booms. Well, things have turned really, really crazy.
Shifting to the Macro environment, this has been an absolutely fascinating quarter. The third quarter was a continuation of an extraordinary market, policy, economic and geopolitical backdrop. I can’t imagine a more fascinating environment. I could talk macro analysis for hours if not days, but I’ll focus on a few of the quarter’s key developments.
First, the wild and woolly Global Bond Markets: Global safe haven bond markets dislocated, with yields collapsing spectacularly in August. After trading as high as negative 0.21% in mid-July, German bond yields were down to a record low negative 0.72% by August 28th. Record low 10-year yields included Swiss bonds at negative 1.20% and Japanese bonds at negative 0.30%.
After ending July at 2.01%, 10-year Treasury yields sank 51 bps in a month to 1.50%. Two-year yields recently traded at 1.40%, down from January’s 2.60%. Negative-yielding global bonds reached a record $17 TN in late August, after beginning the quarter at about $13 TN - and January at $8.3 TN.
Fixed-income markets turned manic and buying indiscriminate. Italian bonds were a case in point. After declining almost 40 bps during the second quarter, Italian 10-year yields sank 130 bps during Q3 to a record low 0.82%. Greek yields dropped 110 bps during the quarter to a record low 1.35%. $434 billion of bonds were issued globally in September, an all-time monthly record. In the U.S., issuance boomed as investment-grade corporate risk premiums dropped to the lows since early-2018.
Bonds were certainly responding to expectations for aggressive concerted global monetary stimulus. The Fed cut rates in July and again in September. The ECB further reduced negative deposit rates and restarted QE on September 12th. According to the FT, almost 60% of global central banks reduced rates during the quarter – the biggest proportion since the crisis.
Argentina’s August default further rattled markets, with contagion spreading to other emerging markets. Fears of hard Brexit chaos also weighed on sentiment.
The global economy weakened during the quarter, but aggressive stimulus measures were more in response to risks associated with the expanding U.S./China trade war. There was considerable focus on the Chinese economy throughout the period. The quarter began with notable instability in the Chinese money market. Smaller financial institutions lost access to borrowings, as fallout spread following the government takeover of Boashang bank. Beijing responded with huge liquidity injections.
China’s currency came under heavy selling pressure in early-August, dropping over 4% in five weeks – as it broke decisively through the key 7 level vs. the U.S. dollar. Total Chinese system Credit growth slowed markedly in July, only to bounce back in August and September. I don’t believe it was coincidence that instability in the U.S. repo market followed by weeks Chinese money market instability. An important theme during the quarter was the heightened instability that began to materialize throughout global finance.
I similarly don’t believe it was coincidental that the spike in U.S. overnight repo rates erupted the week following an abrupt reversal higher in bond yields – including a notable one-week 53 bps surge in benchmark MBS yields.
I’m confident in the view that enormous speculative leverage has accumulated throughout global fixed-income markets. In particular, this year’s spectacular yield collapse – that went to blow-off extremes during the quarter – was surely fueled by speculative leverage and derivatives-related buying. A spike in bond prices – a collapse in yields – spurs powerful self-reinforcing buying, as the hedge fund community covers shorts and positions long – and those that sold various derivatives against declining market yields scurry to buy bonds to hedge escalating losses on these contracts.
News and analysis follow market direction. Global yields collapsed, and the U.S. yield curve inverted. The media then immediately turned its focus to expectations for a rapidly weakening global economy and U.S. recession. Meanwhile, financial conditions loosened. When economic data turned more positive in September, the bond bubble was vulnerable.
After declining 50 bps in August, 10-year Treasury yields surged 40 bps in September’s first nine sessions. Global yields similarly surged. Overnight U.S. repo rates spiked to 10% on Tuesday, September 17th, and the Fed for the first time since the crisis intervened to inject liquidity into funding markets. After initial efforts failed to return rates back down to normal, the Fed boosted the size of overnight funding auctions while expanding operations to include 14-day term repos. In four weeks, Fed Credit expanded $183 billion.
And then last Friday the Fed announced it would be expanding its T-bill holdings by $60 monthly through the first half of 2020 – operations that will expand its balance sheet by hundreds of billions. The Fed is saying it’s not “QE,” but that’s semantics.
Analysts blamed the spike in repo rates on an unusual confluence of factors: notably heavy Treasury issuance, quarterly corporate tax payments and the approaching quarter-end funding tightness. I viewed repo instability in much more serious light – an important indication of systemic fragility - and it would appear the Fed sees things similarly.
I believe a decade of near-zero – and even negative rates – along with unrelenting global QE has fueled an unprecedented buildup of leverage at home and abroad. As I wrote in Friday’s CBB, I suspect the size of “carry trades” and myriad forms of speculative leverage dwarf those from the mortgage finance Bubble era – having seeped into all corners, nooks and crannies of global fixed-income markets.
I highlighted some BIS data that confirm a massive expansion of credit originating from off-shore financial centers, most notably the Cayman Islands and Luxemburg. And in my analysis of the Fed’s quarterly Z.1 credit data, I have highlighted a $700 billion nine-month surge in the Fed’s “repo” category – that I see as corroborating my analysis of a manic speculative “melt-up” dynamic.
I hold the view that unprecedented leverage – many, perhaps tens of Trillions - have accumulated in U.S. fixed income, in Chinese Credit, European debt, dollar-denominated bonds globally and higher-yielding EM debt more generally. I believe short-term securities funding markets – both onshore and offshore – surreptitiously became the epicenter for unprecedented leveraged speculation globally. And every time central bankers intervene to backstop market liquidity, they only further embolden reckless risk-taking and leverage.
I fully appreciate how the enormous global buildup in leveraged speculation works miraculously - so long as bond yields are declining (as long as bond prices are rising). Importantly, uncertainties associated with escalating U.S./China trade frictions – and, with it, acute risk to fragile Chinese bubbles - spurred a historic global speculative “blow-off” and bond market dislocation. With global central bankers having essentially promised to do “whatever it takes” to support securities prices, bond markets began anticipating aggressive rate cuts and QE. But if only bond yields could fall forever – even as debt and deficits expand uncontrollably.
At this point, it’s not clear to me how the global system doesn’t turn increasingly unstable, which I believe explains why the ECB and now the Fed have again resorted to QE.
There has been all this talk about “insurance” rate cuts: If central bankers have depleted arsenals, they should use what they have early and aggressively. As the thinking goes, since inflation is low, minimal risks associated with aggressive monetary stimulus are easily outweighed by the obvious rewards from sustained expansions.
This line of thinking is seductive, just as inflationism has proven to be throughout history. It is also deeply flawed and dangerous. Central banks will have less firepower available when they really need it. Yet that’s not the critical issue. Central bank stimulus today is fanning late-cycle “terminal phase” bubble excess. Central bankers will have little ammo later when they confront much bigger crises.
Bond market bubbles have succumbed to historic excess – leverage, speculation, over-issuance, mispricing and myriad other distortions. Speculative leveraging has been stoking global liquidity abundance and the perception of endless market liquidity. Money has continued to flood into bond ETFs, with scant regard for risk. Equities bubbles have been feeding off collapsing market yields and loose financial conditions.
In my view, we’re witnessing a historic global speculative blow-off in financial assets – safe have bonds, equities, fixed-income, derivatives, cryptocurrencies and the like. I believe excesses have accumulated throughout international derivatives markets way beyond those from the mortgage finance bubble period.
And after this summer’s global bond market speculative blow-off, fixed-income markets are increasingly vulnerable to a destabilizing jump in global yields. And I know all the talk is of Treasury yields following German bunds and Japanese JGBs much lower. But with deficits approaching 5% of GDP, Treasuries are vulnerable to supply and demand dynamics. That’s one of the signals being delivered by upheaval in the repo market.
One of the major costs of QE and “whatever it takes” central banking has been a complete breakdown in fiscal discipline. The current complacency regarding spiraling federal debt recalls the lack of concern for mortgage excesses during the previous bubble period. Rapidly inflating quantities of credit - of deteriorating quality - at rising prices - is unsustainable.
I hold the view that the global financial system is now highly vulnerable to a bout of destabilizing de-risking/deleveraging. During Q3 we saw cracks – cracks in China’s money markets, EM bonds, U.S. overnight funding markets and global bond market instability more generally. Beijing has once again prodded their banking system into aggressive lending.
Meanwhile, the ECB and Fed have again resorted to liquidity injections. Central to my analysis, such measures work only to extend the cycle of speculation, leveraging, resource misallocation and economic maladjustment.
It’s also worth noting that despite generally strong markets, performance issues have been impacting segments of the leveraged speculating community. There was the August default in Argentina, with contagion effects reverberating through key emerging bond and currency markets. Some speculators were caught short Treasuries during the melt-up, and others were whipsawed by extreme yield volatility. There were also the previous discussed short squeezes, and the so-called “quant quake” back in early-September. “Long/Short” strategies, in particular, were hard hit during a violent sector rotation. Some sizable funds have performed quite poorly in 2019. And internationally, there have been a few large funds suffering through acute illiquidity. These types of performance issues are a characteristic of markets tops – with poor performance quietly working to reduce risk tolerance - boosting the odds that “risk off” de-risking/deleveraging dynamics take hold in the event of a market downturn.
I currently don’t have a strong market view for Q4. I believe there was significant hedging ahead of recent trade talks. For now, it appears the most feared outcome may have been avoided. It’s not clear to what degree the unwind of hedges could fuel equities, or if a rally might incite animal spirits and anticipation of a year-end rally.
But I do believe global fixed-income is vulnerable here. Credit has been expanding robustly in China, which for now supports their historic bubble. And it would be atypical for the U.S. economy to succumb to recessionary forces in the face of such loose financial conditions. Markets have priced in ongoing aggressive monetary stimulus, while the major central banks face growing internal dissent.
We’ll see if the FOMC is really determined to cut rates again with trade tensions easing and stocks near record highs. The markets currently have an 83% probability of a Fed cut at the end of the month, a very high number considering the less dovish views of many on the committee. If we are at the cusp of a trade truce and a Fed on hold, I’d see bond markets as highly vulnerable.
The long list of risks to the great bull market seems to only expand: market dynamics, speculative leverage, the global economy, monetary policy, China, the impeachment inquiry, geopolitics, the coming election cycle to name the more obvious. I believe global markets have been signaling trouble ahead. It should be another fascinating quarter for analysis and a challenging environment in the markets.
I’ll conclude this segment noting the sudden travails that afflicted the IPO marketplace during Q3, one more indication of the shifting liquidity and market backdrop. For WeWork, it’s been one rather precipitous fall from grace – from Wall Street darling to fighting for survival – in a span of a few short weeks.
It’s a timely reminder of how dramatic things change when a highflyer loses access to cheap finance. I expect WeWork to prove a harbinger of things to come. After a decade of the most egregious monetary stimulus imaginable, an awful lot of uneconomic enterprises have proliferated in the U.S., China and globally. A tightening of financial conditions and waning liquidity will come with major ramifications for markets, economies and geopolitics – and not for one minute do I believe central bankers have things well under control.
There are some ominous parallels to the waning days of the tech Bubble, but this also reminds me of the summer of 2007 – at least so far – probably more so than the 2000/2001 Bubble deflation. Back in mid-‘07, Citigroup’s Chuck Prince famously quipped “we’re still dancing.” Yes, the bubble was inflating – M&A was hot, debt issuance and private equity were booming, the economy was strong. But there was below the surface a subtle shift unfolding – the marginal mortgage borrower was losing access to cheap finance. Few appreciated it at the time, but the great mortgage finance bubble was faltering. When subprime derivatives and securitization markets stumbled in the summer of 2007, the marginal home buyer lost access to affordable mortgages. Home prices began to falter, lenders became nervous, buyers pulled back and the bubble began to deflate. Not appreciated at the time was the role that speculative finance and leverage had played during the bubble, and how the associated liquidity and purchasing power from mortgage finance had come to play such a dominant role in both the securities markets and overall economy.
Today we’re seeing – what I’ll call subprime businesses like WeWork – and we can certainly throw in the Shale operators – they have begun to see less availability of cheap finance. And this is how it starts – the subtle turning of the cycle. Now the marketplace will look to see who else could be exposed to the changing landscape, and there’s suddenly renewed interest in balance sheets and cashflows after a decade when they didn’t matter. I look at tech, software, energy, media, telecom, biotech and a number of other sectors as having been operating in “arms race” dynamics. Why not just throw money at any opportunity? But we’re now at the early stage of a tightening of financial conditions – at the margin - for companies that have operated at the fringe of financial viability. And I believe we’re only a market break away from this dynamic expanding to more of a 2000 to 2002 scenario. I’ll add that the current “tech bubble” is at a global scope so far beyond the late nineties. I have said that the current environment has ominous parallels to 2007, early-2000 and the 1998 global crisis.