So What The Hell is Going on Here

Let’s say this sphere represents your portfolio. The red part is the core of cash you have deposited through your work, aka your human capital. The corona represents cash you have converted into diversified assets. Each one has a direction and a height above the red sphere. If you draw a larger sphere around the corona just touching the tops that volume represents total portfolio value, The difference in volume between red and the larger sphere is the gain you get by investing. Most of us run long only portfolios so we throw away half the potential gain


I’ve traded spreads in the past and they are tricky mothers fraught with danger so it’s reasonable to throw away half the sphere to throw away half the risk. There is nothing buy and hold about trading spreads and it’s a probability game. You have to be right more often than wrong, and you WILL be wrong.

Diversity comes from spreading your eggs (invested money) across the face of the sphere. By investing in many pretty unrelated non correlated directions you can maximize the volume and if any single corona falters not much happens to the volume. Each corona has it’s own 3 space direction and each has its own size. In the picture they are all uniform but in reality we construct our portfolios to be distorted as opposed to be spherical because the distortion seems to provide some out-sized advantage when it comes to profit. In reality we do have dozens of choices and we make them We have US stocks with US large cap US mid cap US small cap each with growth or value tilt. We have foreign with the same litany of categories. We have EM. We have commodities, softs, metals, oil etc. We have bonds upon bonds to choose from both foreign domestic corporate and government of all different duration. We have Real Estate. We have private equity. We have credit debt and interest assets and we have derivatives available for all of these.

We like simple so we lump all this stuff into like bundles Total Stock Market foreign and domestic, Total Bond Market, Commodities baskets, Real Estate baskets etc. If you have a whim there is an ETF that can satisfy your need. There is one last asset CASH. Cash is the risk free asset cash is the red ball. When you buy baskets you loose access to price. Your baskets are not the same as what the contents are individually. As the market oscillates the corona can move on the surface. They “tend” to have pretty constant diversity. Diversity is the angles and distance between 2 corona. The baskets of corona also move around the surface and baskets also have diversity but a different diversity from the underlying. Baskets also have risk. A different risk than the underlying.

In low volatility times (the last 11 years) everything is well behaved. All of the underlying and baskets all float around on the surface is some fairly predictable relationship. Bonds are low volatility, and tend to behave in fashion unrelated to how stocks behave. Commodities don’t pay a dividend and are extremely inflation sensitive so they float around in a very different place.

Capitalism dictates people will try and maximize their personal as well as corporate profits. It’s a fair enough system where you take some risk and hope on some reward. You may try to guild your lily and maximize profit by taking out sized risk while others want to make a little but not risk too much. A lot buy stuff and don’t have the first friggin’ clue what they are doing. They just follow some simple 4th grade math. When volatility is low this works out because simple math is good enough. The monkey business of trying to guild every dollar often leads to buying way too much risk because as a profit seeker you ignore the risk and just hold out your hand to get paid! That kind of strategy works if you’re a day trader because you put on risk and take off risk every day and if you bet right you get paid. I spent the 90’s day trading once trading costs got down to $5.

Buy and hold types access the same kind of risk taking, except they only put on risk, they never take it off. They also never pay attention to risk. They just plow into an unknown sea head first and pray God there is no rock just below the surface.

Sometimes the universe changes and volatility kicks up along some asset class and the risk becomes more dramatic. So if the VIX which measures the risk on the S&P is 15 for a decade you become complacent and just keep chucking dollars into the S&P because if seems to always pay you with 11% return on the average sometimes more but on a year over year basis it delivers the good. Then on week he Vix goes to 75 a 5 standard deviation move, and the S&P is at all time highs 100% above the long term mean. Suddenly there is 1% upside and 99% downside and you move down 130 points the biggest point swing ever. Moving down begets moving down and the VOX stays 5 standard deviations over the past decade and yet again you move down 260 points. then 2 days later the vix stays high and you move down 336 points. that movement down is not linear it’s a power function. You’re movement up was pretty linear about 11%/yr but down we will be at zero long before a year plays out. So that’s point one. Trading has moved from a linear function to a power function.

The next thing is what’s happening across asset classes. Firstly diversity is collapsing. In a power function environment all correlation in an asset class tends to 1 aka unity and it all heads toward zero. Also all risk therefore tends to unity so if you were expecting those foreign stock to save you they will kill you worse because they have lower return and higher risk even though they did provide some diversity when the relationships were linear.

The non correlated assets also have volatility. Bonds have the MOVE index, Gold has the GVZ index, Commodities tend to use oil (OSX) as the volatility proxy. All of these other volatility indexes are also blowing up by standard deviation amounts meaning they are also going to a power function. In normal diversity if one dimension blows out its vol the others maintain low volatility and anchor the portfolio to a relatively mild shock. If the vol of all the diversity dimensions are going to the moon (stocks bonds commodities gold currency are blowing up the internal volatility of that system is frightening. The clip is this. Ignore the politics and focus on the nature:

Imagine you are skiing 5 feet in front of the avalanche. What could possibly go wrong? To me risk off seems prudent, In fact I sold my entire stock portfolio Friday and today. My apparent loss year over year is 5%, which means I lost all of last years gains from March on, all of this years gains and a little more. I kept the bonds and the gold, but I’m keeping my eye on those too. I have no problem going risk free (aka cash) if the situation warrants it. I didn’t come to this to loose half my money based on a narrative.

I may be wrong and the S&P will explode 2000 points by Friday. Doesn’t matter I booked my gains because I did book quite a lot of capital gain, effectively I bought low and sold high which is the point. The reason I don’t see this happening is the Virus. Several states just closed down restaurants, a low margin business. That means unemployment went up, and it may be permanent. To smash the peak you have to extend the base. If the peak is expected in 12 weeks, a 50% smash results in 24 weeks because the volume has to be equal. Immunity happens only through illness at this stage of the game. That means the same number of people have to become immune regardless of the smash. How many restaurants will survive a 6 month forced closure? What about lettuce growers? They supply the salad makers in the above restaurants If the restaurants are closed I’m not growing any lettuce and if I’m not selling lettuce I’m not paying the mortgage or my farm hands, and so on and so on.

Look at the clip again and think long and hard about buying that dip. I could well be wrong, but I bet my fortune on that analysis. There is always something to do, including nothing. The trick is to do what is wise. At some point some are going to win and some are not. Check your narrative it may just eat your lunch.

2 Replies to “So What The Hell is Going on Here”

  1. It’s nothing new. This too will pass – give in 12 months. The market is not going to zero.

    At what levels of the market and/or VIX would you consider getting back in?

    1. I dunno I can’t remember a time when where restaurants were ordered shuttered all cruises cancelled all trips and meetings and sports and business travel and school all the way through grad school and med school was cancelled and people are being buried in mass graves visible by satellite and keeling over dead in the street and all the pollution is the most polluted country in the world is gone, church is cancelled and we’re just at the beginning. Seems a little extraordinary and likely some of the ramifications will be extraordinary

      I’ll wait till the indexes get under 2 x their normal volatility. So if the VIX has a normal range to about 15 It will have to get under 30 but I won’t trade till all of the indexes are under 100% of their normal vol. I may not trade even then if we are deep in recession which is for sure coming.

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