By Steve Sosnick, Chief Strategist at Interactive Brokers
Successful traders typically respect the adage “Don’t fight the Fed, don’t fight the tape.” Right now, neither appears to be something to tussle with.
The Federal Reserve has slowed the unprecedented pace of monetary expansion that peaked in June, but the balance sheet has grown at a roughly 10% annualized pace from a trough after a brief decline in July. By any normal standard, that would be an aggressive pace of monetary expansion. That is a Fed that you don’t want to fight.
Meanwhile, I have neither the space nor the inclination to outline all the stocks and indices at or near record highs. While there have been stumbles along the way, even the worst plunge proved to be temporary, and ultimately a buying opportunity. The public has embraced equities with a fervor, and investors have become further enamored with bullish call options that allow leveraged exposure to the seemingly perpetual upside of their favorite shares. That is a tape that you don’t want to fight.
With all seeming so rosy, it seems appropriate that I should stop writing now. It would give us both more time to go out there and buy more stocks, foreign currencies, bitcoins or any of the various investable items that have been making money for bullish traders. But I have more to say. Another adage that traders respect is “be greedy when others are fearful and be fearful when others are greedy.” Is there any dispute that others are greedy right now?
When I wrote earlier that the public has become enamored with stocks, I stopped short of using the phrase “in an unprecedented manner.” This is in spite of sentiment indicators that are at or near their own recent or all-time highs. In a recent piece, I outlined some of the parallels that remind me of the heady days of the 1999 internet bubble. Then as now, we saw an accommodative Fed and technological improvements that gave investors unprecedented access to markets. I don’t imagine that anyone reading this was around during the Roaring ‘20s (1920’s, that is), but its stock market rally was heavily abetted by excessive margin levels that left investors dangerously exposed to a decline.
Required margin levels are far more appropriate now, but remember that options are themselves leveraged investments. Outright call buyers have an advantage over margined stock buyers in that they can only lose their initial premium payment, but options also enable their investors to lose money over and over again. Look at the recent example of Softbank. After a stellar run investing in call options, they recently announced that they will be unwinding that strategy after significant losses. The current wave of call buyers is keeping volatility measures, such as VIX, elevated. Normally, during times of investor enthusiasm we see VIX plunge. Complacent investors see little need to hedge their downside, depressing options prices and implied volatilities.
The current rally has a much more manic quality, with the low levels of the put/call ratio showing that while there is still little interest in hedging downside, there is no shortage of traders seeking to profit from further upside. For the short term at least, the VIX index’ usefulness as a fear gauge is seriously impaired. (For the record, VIX is not now, nor has it ever truly been a fear gauge, but it has tended to act like one nonetheless). Let’s be real — there much for investors to love. Vaccines are on the horizon, and markets are discounting the likelihood that pent-up demand will bring a sharp boost to the economy and corporate profits.
The Federal Reserve has given little indication that they will remove their accommodation before inflationary pressures become evident. That raises the specter of an overheated economy in the latter half of next year. But why worry about that now, I suppose? Markets are fixated on the positives, especially during an otherwise gloomy year. It is tough and even foolish to fight either the Fed or the tape. But experienced traders know that nothing obligates you to join the party either. It is also important to use your judgement to decide whether a bit more fear may be appropriate amidst all the current greed.
This article first appeared on Traders’ Insight
Photo Credit: Sam valadi via Flickr Creative Commons
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