Chief investment officer on liquidity cascades, central bank policy and huge hedging pressures
There is a feeling among some advisors that markets have got “weird”. What’s behind the rebound? Why the heck have tech stocks gone crazy?
One man has taken it upon himself to find some answers to try to make sense of this sentiment that the market is behaving strangely.
Corey Hoffstein is co-founder and CIO at Newfound Research, a quantitative asset management firm, and will be the closing keynote speaker at the upcoming WP Advisor Connect: The Rise of Alternative Investments event. His session, Liquidity Cascades: The Coordinated Risk of Uncoordinated Market Participants, will tackle narratives such as the impact of central bank intervention, the growing scale of passive investing and asymmetric liquidity provisioning (high frequency trading).
He told WP that while the coronavirus was the catalyst that set the market spiralling, the actual spiral was more of an endogenous event as markets became fundamentally broken from a liquidity and pricing standpoint.
Hoffstein saw hedging pressures, a kind of “derivative tail wagging the market dog”, and it set him off on a research project to examine the narratives and ask: why the market is acting differently? He found three main threads. Firstly, that the U.S. Federal Reserve’s policy, aside from creating a moral issue, is forcing investors to take more risks. Secondly, that the growth of passive investing is also creating risk and thirdly, that liquidity asymmetry means high frequency traders are pulling liquidity when it’s needed the most.
He said: “With all these narratives, I didn't find them in and of themselves to be sufficient - there wasn't enough evidence; it was highly circumstantial. But when you started to put all these pieces together, what you saw was this underlying risk that seemed to be latent to all of these narratives. When liquidity in the S&P 500 disappears, the market goes into complete and utter chaos, and a lot of these narratives are putting more and more pressure on liquidity.
“When that exogenous risk occurs, like the coronavirus crisis, it sends the market into this spiral; it's completely procyclical and requires someone like the Fed stepping back in to stabilize the market, at which point the whole cycle begins anew.”
This is not a healthy situation, Hoffstein said, with the huge run-up in the tech names, for example, largely driven by the speculative pressures of short-term call options that were forcing the hand of dealers to hedge in a way that creates huge levered pressure on these individual names.
He explained: “Our market has now become driven by supply and demand, which is no longer necessarily connected to a view about whether a security is good, bad or fair value. A lot of this demand is coming from structured-product hedging, and it's coming from options market makers who are having to hedge their positions from all these speculative calls that individual investors are buying, and it's causing the melt-up and melt-down-type scenarios.”
So what can investors do? How can an advisor take advantage of this situation? The CIO told WP that if you believe the Fed is ultimately always going to step in and have your back, the answer might be to lever up your equities because, as everyone's increasing their exposure to equities with rates at zero, investors are being forced up the risk curve, creating a continued bid for equities.
“Ignore all the bumps along the way because the Fed’s got your back,” Hoffstein said. “If you have a 20-year horizon, that might be the answer. Unfortunately, for most advisors, when you talk about the average-dollar weighted client who makes up their book, it tends to be people who are entering retirement or are near retirement who have already made their money and are much more subject to sequence risk.
“The answer there is actually to think about you can become a liquidity provider during these events. How can you take advantage of market melt-up and market meltdowns? That’s where trying to provide some convexity into your portfolio, either through the creative use of put options or call options, is a good strategy.”