Digital Gamma Notes From Underground

Yet again, the world is facing a crisis and that crisis has a venue in the financial markets. It has a far more important venue in the hospitals across the world and the health professionals manning them. While financial markets can and do impact Main Street, Covid-19 (Coronavirus) is of a separate category unto itself. It impacts all of us. I wish that all of us will look back at this as primarily an event for the financial markets rather than a time of human suffering.

Please read the below note on Brexit that originally appeared in the Trading Technologies blog in 2016.

Here are a few additional thoughts about where we are today. Please do not take any of them as anything remotely resembling investment advice.

1. This is unlike the financially oriented crises of 2016, 2008, 2000. As someone (apologies) put it on Twitter: “The Fed can’t print a vaccine”.
2. “It is very hard to predict, especially the future.” — Niels Bohr (or Danish proverb). I am a huge fan of Louis Gave and just heard him make a number of very convincing arguments at the end of 2019 about why we should be prepared for inflation. Therefore bonds were a bad idea — especially at their low levels. Quite frankly, I consider him to be correct. And yet, I’ve never seen bonds move (up) like they have. What’s my point? The point is that we don’t know what comes next. Although there is great risk of widespread bankruptcies and asset selling, the government will likely look to provide stimulus, both monetary and fiscal. This may set the stage for a turnaround in all asset prices. Especially with Trump and especially in an election year.
3. At least as hard to predict: an oil price war hitting at the same time. The oil price has had disproportionate impact due to credit market selling in energy and also collateral damage on credit markets generally. And that has also created an outsized demand for options (outside the scope of this article).
4. The best times to buy volatility is when it is statistically expensive and the best times to sell is when it is statistically cheap. Except, of course, when it isn’t.
5. There are some significant supply chain disruptions. It is rational and, despite that, even likely that business and political leadership will bring some of that industrial capacity back onshore (wherever that onshore might be) or nearshore.
6. The disease disproportionately impacts the elderly. Political leadership tends to be older. We have a looming pension and Social Security fiscal crisis. Covid-19 has the potential to impact and reshape the US (I’m US based) and the world for decades in unpredictable ways.
7. There is some place for monetary policy to help even if it is not a vaccine. Companies, like the rest of us rushing to Costco for toilet paper, are reaching for their credit lines before the banks run out of money. The Fed can help with that.

With that, please take a look at:

TradeCo Guide for the Brexplexed

Here it is, summer 2016, and I am contemplating at least my fourth “once in a thousand year” event in my trading career: Brexit. The others include the dot-com bubble, LTCM and the 2008 financial crisis. Truly, though, these 1,000-year floods occur with alarming regularity, although not all are so global nor impact markets so widely, e.g., gold in 1999 or Enron in 2001. One of my colleagues thought enough of my opinion to reach out to me. It was at the end of a long night, so I’m not sure how helpful I was. Perhaps this may be of more use.

Have a framework for understanding news. Otherwise market volatility dictates your view.

Some trading notes:

1. There was a lot of trading on Friday. More than a few of us participants are going to check what cleared on our statements only to find that things don’t match. This could cause opening market disruptions.
2. Many of us were up all night trading as results came out. Like many of our all-nighters, there will be a lot of “I did what??”
3. See below, but “Brexit” is likely to be as or more disruptive to Europe as the UK.
4. If you thought liquidity was poor for large trades before, it will likely be worse going forward.
5. Suddenly the future seems far less predictable than two days ago. Just remember it was not predictable then, either. Just now it is priced as though it is far less predictable.
6. This is not a 2008 financial meltdown. At least not yet. Currently, a repricing has occurred based on new information and perceptions of the impact of that information. Wide scale margin calls, banking failures or even suspected insolvency has not occurred, besides the usual rumor Morgan Stanley is going under (down 10%). Again, at least not yet. Given the fore knowledge of the event, the level of hedging that appears to have occurred and the increased margin amounts that have been issued by exchanges and clearers, I’d rate this as unlikely.
7. Revisit #6. Unlikely does not mean impossible. Be prepared.
8. Stretch out your time horizon. Although there is uncertainty, value may present itself for the long run. It is very worth remembering Buffet’s advice when short term fluctuations occur: “Price is what you pay; value is what you get.”
9. With bigger moves, smaller positions can make as much money as larger positions did before — and they are easier to handle.
10. Have a framework for understanding news. Otherwise market volatility dictates your view.

Some Brexit notes:

1. Calm down. This is going to be with us for a while.
2. It may not seem obvious, but the UK is still in the EU. The referendum spoke of the majority’s will, but the UK has not left the EU. That has to be done by British leadership formally notifying the EU. After that, there is a two-year negotiation period.
3. Read #2 again. When we walk in Monday, nothing will have yet changed. The markets are only reacting to what it anticipated in a coffee-fueled night of trading the unexpected.
4. The volatility, while unlikely to reach the crescendo of Friday morning, will continue for a variety of reasons.
5. Cameron has resigned. Although EU leadership has stamped their collective foot demanding that the UK make the formal withdrawal immediate, my best guess is that Cameron’s resignation has essentially taken that off the table. Realistically, the EU foreign ministers can demand all they want; it is up to the UK leadership to formalize the withdrawal.
6. It is even conceivable that the formal withdrawal will not be placed, i.e., it is non-binding. Prior popular referenda have been refuted by EU bureaucrats (certainly part of the reason for the vote as it was).
7. Northern Ireland and Scotland wish to stay. While there is clearly frustration there, until the UK at least formally notifies the EU, it is hard to imagine something changing. And, even then, probably not until some time has passed and the framework for the “divorce” begins to be seen.
8. UK citizens are not the only ones frustrated by unelected bureaucrats making unpopular policies from Brussels. It is very likely other EU countries will follow the UK lead. Although not the only nation, France is probably the most important as it is hard to think of a European Union without France and Germany.
9. It is entirely possible, though not probable, that the EU government will respond to the vote and evolve structures that address the concerns of the national electorates.
10. Either from UK leadership or European leadership, it is possible that if #9 occurs, Britain may decide to hold off its withdrawal and perhaps hold a new referendum based on the new structure.
11. Don’t count on rationality. There are a lot of personalities involved, and based on what I have read, many are taking this very personally: a sort of written frothing at the mouth. It is not obvious that responsibility to the greater community is going to come before ideology and prior loyalty to political/group identification.
12. The current “demand” of EU foreign ministers is a clear instance of this. Any rational third party would not be trying to make a difficult situation more difficult. This simply smacks of an understandably human yet clearly reactionary response.
13. At risk of polarizing people, I’d offer the following as a guideline for long-term, structural economic development of standards of living. I mention it for the purpose of having a framework for putting rapidly updated news headlines in perspective for making trading and investing decisions. There may be a “should be” out there, but we have to trade the markets based on how it actually is.

• Simple and clear laws/rules that apply the same to everyone are positive.
• Self-designated elites enriching themselves using government levers are negative. Why Nations Fail by Daron Acemoglu and James Robinson is excellent in explaining this.
• Organized, open borders are long-run positive but can be painful in the short run. Note that “organized” is a deliberately vague term and might just make this a useless point since it could be appropriated by an ideologue.
• Brittle ideology is negative. We all live here. There is no “average” person; policies impact individuals and groups differently. Few policies, except (a) and (b) are unambiguously good for all.*
• It is better to focus on the common ground of goals rather than prior political stances (good luck with that one!).

With bigger moves, smaller positions can make as much money as larger positions did before — and they are easier to handle.

A little perspective may also help. It is not an exaggeration to compare the mid-2000s and the 2008 global financial crisis as a parallel to the 1920s and these years as a parallel to the 1930s. The short version is that we have had a number of years building using debt as our engine for economic prosperity; this simply moves future growth forward. In other words, we have already spent the money that we would be enjoying today. We spent that money prior to 2008 and the slow growth we have seen is not mysterious, but simply the results that could have been predicted straight from Econ 101 (you can move the cash flows through borrowing, but you still have to pay them back). The aftermath of the 1929 crash and the debt overhang was years of slow or negative growth, political upheaval where ideology trumped practical solutions and, ultimately, war. I’d like to take the optimistic viewpoint that the UK vote is a constructive, collective cry for political leadership across the globe to address the very real concerns of the governed. That if it is properly and responsibly addressed, that we can avoid the mistakes that led to the Depression, authoritarian regimes and, ultimately, a World War.

Given all of the above, it is worth repeating that the UK-EU relationship issue is going to be with us for a while. There will be variations on this news theme originating out of the rest of Europe, and likely globally, for an extended period of time. Like it or not, we live in interesting times. Trading is about dealing with the cards as they are dealt and not as they ought to be dealt. That means to be sure to have a framework for understanding news so that you don’t get buffeted every which way by trivia. Finally, size your trading appropriately; this will allow you to stay calm in volatile markets. After all, these once-in-a-lifetime events happen every few years.

*Spoiler alert. I’ve disclosed a bit of my own ideology. I think that these two hypotheses have been verified by historical precedent, but if you feel differently, then work in your own framework. It is important to have a way to put things in perspective so that market volatility does not create your view.