A few weeks ago, I started to use the car service app Uber after several people recommended it. Now, I use it whenever I can. While its convenience and service cannot convince me of its hefty enterprise valuation ($50+billion), it has converted me to a loyal customer. Another interesting fact I learned is how it is changing the labor market. For less-skilled workers, Uber offers them an opportunity to make more money and have greater flexibility in terms of when they work. As someone who is concerned about inequality and technology unemployment, it is nice to see how technology can help the labor market in a positive way.
Back to the market. In the last three weeks, sentiment has changed sharply. In August and September, the market was worried about a hard landing in China and the U.S. dollar strength driven by the potential rate hikes. On October 2, after the release of a dismal non-farm payroll, the market had a change of heart: Bad news is good again. The thinking goes: If the U.S. economy and labor market slows down, then the rate hike will not happen in 2015, then suddenly the risk-on trade is back on. Besides this, the seasonality is favorable for year-end and the market is still underweight risk.
I am doubtful about this rally. It feels more like a short squeeze driven by bad positioning and negative Gamma (a measure of the convexity of a derivative’s value in relation to the underlying instrument) in the market than a genuine rally. This week's chart shows the 52-week new highs and new lows in the S&P 500 Index, which is not a very promising picture.
The market structure has deteriorated in the last few years as more and more money flowed into strategies with a negative Gamma – hedge funds, smart beta, liquid alternatives, volatility-controlled funds, Commodity Trading Advisor (CTAs), hedging activities from insurance industry, etc. These accounts tend to sell on the way down and buy on the way up for risk management purposes. Risk management is a good discipline; however, when a large portion of market participants use similar strategies for risk management, it can be a disaster. The end result is stampede-in and stampede-out, which makes the market prone to V-shape behaviors. Research from JP Morgan's Marko Kolanovic is a good read to understand these dynamics.
This negative Gamma in the market makes risk management more challenging for anyone with a Profit and Loss (PnL) to manage. It creates a lot of false signals, and the market no longer behaves in a typical back-and-forth fashion. Take a look at how many days we were down in a row, and how many days we were up in a row in the last two months. Statistically low probability events happen much more frequently now. How to adjust traditional risk management practice to better fit this new environment is a question we think about all the time.
Key Takeaways: The recent rally is likely driven by crowded positioning and bad market structure, so stay cautious and defensive. Negative Gamma in the market is creating a lot of challenges for asset managers that need to manage risk actively. New reaction functions are needed to better fit the current market environment.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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