• Market Volatility has been fueled by a changing landscape for the larger management models and has been aided by political, fundamental, and technical factors.

  • Oil has been pressured by compressing crack spread readings, but OPEC and Shale production cuts could help to forge support.

  • Sentiment data around extremes in hedging suggest the there is a potential for a “Max Pain” rebound into year-end.

  • China may not want a trade agreement?

During this bull market, because of an overextended period of historically low interest rates, and concerns about deflation rather than about inflation, more and more “managed money” has migrated into a “risk parity” model. That is, stocks and bonds are presumed to be mutually protective hedges for each other, and risk covariance remains under 1.00 for those diversified in both asset classes.

With the breakout higher in interest rates at the long end of the treasury curve in late September (a move that was not caused or accompanied by a breakout of higher equity prices), this risk parity approach (typically a 70/30 Stock and Bond portfolios) was hammered mostly due to model-based managers having to raise their guards about risk on the bond side while and decreasing their confidence in the belief of negative risk in their overall portfolios. The way to actually prepare for circumstances like this one is to increase the cash on hand.

In simple terms, when the yields on the long end broke out and equity prices did not, the traditional stock/bond portfolio model that a majority of fund managers have been using as their bread and butter had to be altered. The viable way to remedy the risk appetite in an instance like that is to increase cash levels.

Given that there’s near a half-trillion dollars managed in the above risk parity strategy, the impact of a widespread failure of the model has relatively dramatic consequences for equity prices. My belief is that this is the primary driver behind the initial downside momentum we saw in early October.

Another major factor likely contributing to the downward momentum is the rising expectations for direct supply in the bond market in 2019. Currently the supply is around $1.5TRILLION. This comes as a consequence of “yuge” anticipated budget deficits and the Fed’s plan to roll $500 billion off its balance sheet during that same time. These issues suggest to managers that the failure in the model for risk parity is likely not going to be “quick fix.”

In addition, likely helping to undermine the market over the past 6 weeks are two other big factors.

  1. Q2-Q3 of this year is a strong candidate for cycle highs in both earnings and economic data due to the initial psychological impact of the sense that fiscal stimulus measures “are having a greater impact than anticipated” as noted by the Fed earlier this year.

    That suggests extremely difficult comps on the way in 2019.

  2. Now that the elections are over, Democrats are taking over leadership in the House of Representatives. The implication is such that if the market was counting on Trump to push for further stimulus next year to inflate the market and economy into the campaign season ahead of the next presidential election. With the House in control of the Dem’s, Pelosi and Democrats will likely present obstacles on that path that will be difficult to hurdle. This further suggests rough comps ahead, as argued above.

As we know, the market does not simply move on the economy being great, reports of what has happened, or random upgrades/downgrades. The market is a function of future earnings growth relative to expectations. In order for sustained moves to continue, the growth has to maintain up and to the right relative to the risk and expectations. We also know that the higher the bar is, the more difficult it is to jump over it. So with this insight, we know how difficult 2019 could be.

Some weakening in Q4 guidance from big-cap tech over recent weeks has certainly done nothing to temper this new bearish tone in the tape.

We may be in a pattern currently that acts as a doppelgänger to the fall of 2015, where we see a beta chase into the end of the year, but a swift resumption of risk-off activity in Q1 2019. This time around however, we likely won’t have a massive safety net of fixed income money coming over into the stock market as we did in early 2016 when 70% of global sovereign debt in the developed world was trading at negative yields.

Max Pain

One reason it’s possible to see “Max Pain” type upside into year-end is due to something called the “Equity Hedging Index” put out by This measure takes into account six different hedging factors:

  1. Cash levels

  2. Put buying

  3. Inverse ETF buying

  4. Inverse mutual fund buying

  5. Short interest in equity index futures

  6. Long interest in CDS markets

The Equity Hedging Index compares each of those six factors to its historical average, and then constructs an overall score from those relative scores. It has been a good guide over the years, marking points when too much cash is saved due to a concentrated belief of sudden bearishness.

Right now (as shown below in the chart) this index is scoring at levels that have marked major bottoms during the bull market. The last time it scored this type of level and the market did not immediately move to new large timeframe trend highs was in early 2008 (when it hit 85 in mid-March 2008 on the Bear Stearns collapse).

It hit 86.5 at the lows in late October, two weeks ago.

Just to be clear, only this measure and the “Hulbert Stock Newsletter Sentiment Index” are showing significant bearish consensus extremes right now.

Equity Hedging Index. Source:

It is important to note however, at that time in mid March 2008, it did mark a low that was followed by a strong two-month rally that saw over 13% in upside for the S&P.

SPY 2008 13% Rally off the sentiment lows.

Crude Oil and Energy Complex (USO, UGA, BNO, CRAK)

Recent sharp selling in crude oil is likely the product of the build-up of a glut in gasoline levels at major refiners. The best way to see this is in the contraction of the gasoline crack spread – the difference between the input cost of crude oil and the output selling price of gasoline (The margin for gasoline refining).

Below is a chart of the price of a barrel of gasoline minus the price of a barrel of oil, which approximates this idea very well. This suggests that oil prices have been falling in anticipation of a big drop in demand for oil from refiners on the way. 

Russia is also allegedly buying Iranian oil and selling to the world. This is softening the “supply-destruction” impact of the Iran sanctions being enacted and enforced by the Orange Man. OPEC is attempting to curb this as talks of production cuts have surfaced.

As far as key levels, the stars have aligned very nicely and we’ve seen a sharp puke down under $60 on aggressive selling. The $58 area, where we found support in February, has been breached. As of now we are on “oversold levels” and hanging on to a small uptrend.

That $58 area represents extra importance because it also lines up with what’s widely understood as the common line in the sand for whether or not US shale producers can profitably operate. That industry has become the most flexible in terms of shutting off and turning on supply centers. Therefore, it represents the potential to cut US production if the threshold is taken out to the downside. (A takeaway here is that the longer we stay under $58 the easier it is to short/sell US Shale stocks)

Gasoline/WTI Crude Equal Volume Price Spread

WTI Crude Oil (USO)

Brent Crude Oil (BNO)

Refiners ETF (CRAK)

The EU and Italy (FXE, EWI, VGK)

If Italy exits the EU and “redenominates” its debt into Lira, the actual value of that debt will plummet in spectacular fashion as it will no longer be supported by the stool of the EU and the far stronger economies up north. Those holding that debt will only be able to hedge the risk of this event by owning the 2014 minted Italian debt CDS contracts. This is akin to the 2008 MBS crisis.

As of yet, we haven’t seen a big divergence in these contracts, which suggests the world is not yet taking the current spat as a risk to Italian membership in the EU. 

The Euro Continues to Tumble.

Euro (FXE)

European Equities (VGK)

China and the Trade War

The Trump/Xi meeting is set to take place in Argentina toward month end at the G-20 summit. Trump has suggested that the meeting holds “great potential” for a trade deal with China. Trump is likely full of shit, per usual.

I believe that China does NOT want a trade deal with the US.

China wants a long-term change in the protectionism rhetoric and China-hawkishness in the US. The only way to accomplish this is to sit through the storm and use stimulus and currency devaluation until the Trump administration is out (potentially) of office in two years. 

The important factor here is that Xi is a "Leader for Life" in China. The power structure in Beijing is not remotely vulnerable at this point. In other words, the people making the calls are not suffering in the least and will remain in charge long after the 2020 US presidential election barring any “accidents.” Unlike the Orange Administration, the Chinese don’t have to worry about public perception or public approval politics, they can sit out as long as they deem necessary.

As we saw in the mid-term elections, the ability of the GOP to generate powerful support from its largest donors was hampered. The likely the reason for this is because its largest donors hate the trade war and want the tariffs to end. The GOP is a split party, with some of it following the populist tradition of Trump's lead and some of it belonging to a more corporate, free-trade philosophy that has been offended by the trade war from day one.

My belief is China may well believe that it's “one down and two to go” with respect to the House, Senate, and White House over 30 months of withstanding the tariffs -- given that the White House hawks will need Congressional support to enact domestic policies capable of painting a positive narrative into the 2020 campaign to garner enthusiastic support from the same base that drove them into power two years ago.

The price to be paid over this 30 month stretch is the toll that comes with potentially avoiding decades of US hawkishness against China. This US hawkishness is a real danger that may follow if they “reward” the White House tariff strategy with a big win.

If any of this is occurs or has the potential to occur, then at some point, the Orange Administration sees the threat and starts to look for a way to make its biggest potential donors happy well ahead of the next election by backing out of tariffs. 

This feeble attempt could come in the form of one last very hardline attempt to force its preferred conclusion with China. Likely a dramatic increase in tariffs packaged with a compromised trade deal offer. A bogus “Art of the Deal” move that the Chinese would likely balk at. Seeing how there has been no true “plan” at some point the bluster will be forced to reconcile with action.

Shanghai Index (ASHR)

Environmental Evolution

As a final thought, I want to visit an argument I read about and suggest it may be a real factor in the mix going forward.

Imagine a mountain top Lake. The water collecting in the lake is entirely salt free. The life that has evolved to live in the environment of this lake would be life evolved entirely around the premise of an aqueous environment containing no salt. Everything that evolved into the niche of that environment would be of a physiology predicated upon no salt.

Now compare that with a fringe environment that exists on the border of freshwater and saltwater – something like a tide pool just inside of the contours of the saltwater beach.

Life forms there that have evolved to live in this environment would have a physiology predicated on withstanding a dramatic variation in salt levels over time.

The question here is what would happen if you take a fish from the mountaintop lake and release it into the estuary.

The metaphor here relates salt to the cost of money, or interest rates. Our current market cycle and business cycle was very slowly baked with unprecedented artificial suppression on interest rates. 

Typically, there is always a stage of a market cycle that is like the mountaintop lake (interest rate suppression). But it’s normally over quickly as the salt volatility of the estuary leaks into the picture with strong signs of early cycle growth.

This time around though, the mountaintop lake remained in place for nearly a decade. This has been enough time for someone in high school to go to college, join a frat, get a girlfriend, get blackout drunk and get alcohol poisoning, cheat on his girlfriend, join a rock band, contract an STD, break up with his girlfriend, get a DUI, decide to change his life, get into a finance program, talk to his rich uncle in investment banking, get an MBA, go to Wall Street, intern at a fund, get good at networking, raise enough capital to start a small fund himself, and get a few years under his belt sending out investor letters as though he’s a professional. Whole funds have risen and fell all inside the mountaintop lake context. The STD, however, remains. Sorry Chad.

That is extremely strange historically. It suggests a compounding development of “fragility” as we now migrate clearly into the fringe environment. The fact that over $500 billion has been in the hands of risk parity managers (and much more if you take into account those managing their 401k’s with robo-advisers which use basically the same strategy) is a testament to this odd evolutionary situation we now face in global finance. 

There are plenty of people cumulatively managing massive amounts of money who don’t have any direct experience in anything other than the mountaintop lake. To suddenly be dropped into the fringe environment is a truly dramatic moment. 

Add to that an insane person who holds the fiscal balance in his stubby orange paws and it likely spells out serious consequences for the path moving forward


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