Crowded trades and market volatility.

The “Olympic Slide” continued this morning. Concerns about the strength of the US economy continued to spill across risk assets. The S&P 500 erased $2.1 trillion of market cap at the open, placing the total market cap losses since July 16th at ~$5 trillion (X%).

Market rotations like these can occur several times a year (though this one is unique in severity). There’s no singular thing to point to as the cause of this rotation - it’s more of an amalgam of risks that have compounded. More below.

After weeks of economic exuberance, Friday’s jobs report was more sobering. We’ve seen rising unemployment rates, deteriorating consumer confidence, rising delinquencies on debt repayments, and cautionary outlooks from retailers. If you had a recession checklist, these items would be on them. However, this data isn’t necessarily new. We’ve been seeing these trends play out for several months.

So what was the straw that broke the camel’s back? Here is one possible explanation:

1/ Groupthink. Heading into earnings, being long stocks (especially the Magnificent Seven), short (betting against) volatility, and short the Japanese Yen were very popular trades. By many metrics, they were at/near the 100th percentile of crowdedness in July.

2/ A Japanese butterfly effect. Japan has kept interest rates close to zero for nearly 30 years now. A low interest rate environment has encouraged investors to take part in what’s called a ‘carry trade.’ Carry trades are when an investor borrows in a currency with low interest rates, such as the Japanese Yen, and reinvests the proceeds in higher-yielding assets elsewhere. The trading strategy has been hugely popular in recent years, and it’s rumored that several trillions of dollars has been invested using this playbook. A recent departure from zero interest rates has caused the Yen to rally which is causing that crowded trade to unwind – a potential explanation for the overnight panic we saw in Japanese markets.

3/ Options. Friday, August 2nd marked the largest session of options volume on record. This suggests that the crowded trade of betting against volatility was forced to start unwinding. To unwind these positions, volatility has to be bought which creates a negative feedback loop. Buying volatility creates, you guessed it, more volatility.

4/ 1+2+3 = perfect storm. Disappointing earnings from the Magnificent Seven (the third and final crowded trade) likely resulted in some serious profit taking over the last couple of weeks as well. Add increasingly negative economic data and investors are uncertain about the path forward for global markets.

So what do we do?

Stocks already looked stretched to the downside in the short term heading into today, but we’d argue that there may be more selling pressure to come until some of the volatility stabilizes.

As a result, we’ll patiently wait to see some signs of reversal before we start adding to any of our higher conviction positions. We believe business quality matters now more than ever, and we’re pleased with our positioning across all three of our actively-managed strategies: concentrated in what we believe are our highest conviction companies, with some strategic cash on the sidelines to be able to take advantage of volatility like we’re now seeing.

At the same time, we have been closely monitoring the technical indicators we use to determine whether or not we implement hedges (including, but not limited to, moving averages and confirmed downtrends). Despite the last few days of volatility, these indicators have yet not lined up to warrant the addition of hedges, but we’ll keep you posted if this changes.

To sum up, pullbacks like these are a normal part of investing in equity markets. Although we don’t believe we are in a mechanical “buy-the-dip” environment, we see increasingly attractive opportunities emerging to put more dollars to work in select companies. As always, we’ll let you know when we do.

Onwards,

– Your Titan Team

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