Posts

The Social Good of Bubbles – Part II

Written by Tiffanie Bederman (LinkedIn profile)

In my last post I discussed the need for a concrete definition of “bubble” if we’re to use the concept for trading/investing (as opposed to cocktail party hyperbole) and listed a few famous bubbles. These so-called bubbles (here I’m using the term to imply a rapid increase in price and a subsequent, dramatic decline) can roughly be attributed to three sometimes concurrent causes:

New/Unexplored Frontier or Industry

  • South Sea Company
  • Railway Mania
  • Automobile Manufacturing
  • Tech Bubble/Dot-Com Boom

Enabling Financial Conditions or Innovation

  • Tulip Mania
  • Railway Mania
  • Beanie Babies
  • Subprime Mortgage Crisis

Fraud or Morally Questionable Business Practices

  • South Sea Company
  • Railway Mania
  • Black Tuesday
  • Tech Bubble/Dot-Com Boom
  • Subprime Mortgage Crisis

Good Bubbles

From this framework, we can see that some bubbles are the natural byproduct of an emerging industry. With the exception of the South Sea Company – who’s original intention was to reduce the British national debt under the pretense of exploring the new world – all of the bubbles in this category created or revolutionized an industry.

Railway Mania created a vast network of tracks across the UK. Automobile manufacturing created the industry we know today – you’d never drive a Duryea (the first company in the US to build gasoline fueled vehicles), but four years after they got their start, Oldsmobile started building cars as well. In the tech bubble, everyone loves to remember pets.com who’s IPO in 2000 raised $82.5mm, but let’s remember that Amazon’s* IPO had been just a few years earlier in 1997. At $18/share they had raised $54mm. One sold dog food over the internet. The other sold books.

In nascent markets, valuations must be based not just on a company’s future performance but also on estimates of the entire industry’s growth and the company’s ability to perform in turbulent, continuously evolving conditions. When looked at holistically these valuations can reach exorbitant levels that can perhaps be attributed to hubris – market participants all believing *their* horse is the winning horse.

Price > Intrinsic Value ≠ Bubble

According to Shiller, “Gold itself is a sequence of speculative bubbles, starting in ancient times, and still continuing after thousands of years.” Proponents of gold will likely want to argue with this assertion, but consider for a moment that less than 15% of gold mined goes towards fabricated products. Out of the ~$7.7 trillion of gold ever mined, over $6.5 trillion is either held as an investment by central banks, institutions, or individuals or held as jewelry, so let’s stop claiming that “gold has industrial applications” when estimating its value. Gold has value because people have decided that it has value.

For those who disagree with my gold analysis, consider the slightly more complicated diamond market. According to a 2011 report published by Bain, “Per carat, the cost of mining a natural colorless diamond runs about $40 to $60, and the cost to produce a synthetic, gem-quality colorless diamond is about $2,500.” Cutting a 1 karat stone costs between $10 and $100 (linked article provides a good breakdown of the market). Ultimately, these will sell for anywhere from $1k to over $20k, depending on the four C’s, GIA registration, retail outlet (Tiffany’s vs Overstock.com), etc.

Other examples of similar stores of value are gemstones, geological findings, baseball cards, collectible coins, antiques, classic cars, stamps… the list goes on.

No sane trader would short gold or diamonds or collectibles based solely on these analyses. As a post-barter society, we’ve agreed to use objects as stores of value, gold and diamonds included. Cash objects store agreed upon values directly translatable to dollars, euros, etc. History, though, reminds us that cash objects are not the equivalent of money – just ask anyone who has old lira or 500 rupee notes stashed under the floorboards. Bank accounts are arguably the most literal definition of stores of value. The bank gives its customers space in their databases. Customers give the bank money with the expectation of being able to get at least the same amount of money back in the future. But I digress.

Thoughts on Current Markets

Cryptocurrencies

As of January 23rd, 2018, there are 1,476 cryptocurrencies listed on coinmarketcap.com for a total market cap of $526 billion. For traders who believe that cryptocurrencies are a bubble, the more interesting question they should be asking themselves is “what type of bubble is this?” Is the emerging industry the cryptocurrencies themselves or is it the much broader category of blockchain technology? More specifically, recalling P2P e-commerce, are cryptocurrencies simply the Beanie Babies of blockchain, or are they more like the tech bubble producing some huge winners and a plethora of losers? Which one(s) are Amazon and which ones are pets.com? Additionally, will financial regulations enable the development of the market or will new regulations stifle cryptocurrencies?

My opinion: the intrinsic value of cryptocurrencies is not dependent on traders or investors watching financial markets from the comfort of their home or office. It also should not be dependent on Silicon Valley trying to circumvent financial regulations. The value of cryptocurrencies lies in their ability to store value when surreptitiously crossing borders or when compared to currencies going through phases of hyperinflation (would you rather own Venezuelan bolívares or Bitcoin** for the next 30 days?). It’s for travelers who’d rather pay exchange rates and transaction costs than carry large sums of cash, it’s for refugees, it’s for criminals, it’s for individuals who want to electronically send money immediately when the Fed wire is closed. Perhaps someday we’ll be able to get rid of our bank accounts and buy a car at a dealership with Bitcoin but for an immediate investment thesis rather than a science fiction novella I have to assume this isn’t the primary use case.

The Stock Market and Credit

With financial news labeling the stock market a bubble one has to wonder what type of bubble we’re in. Given the known universe of stocks, it can’t be a new or unexplored industry. With no major changes in regulations regarding leverage and no immediately perceptible financial innovations the second category seems unlikely as well. This leaves fraud or morally questionable business practices, which have no reason to have increased in recent history. While I believe a correction would be a reasonable market action (especially if/when inflation starts to tick up), I’m not anticipating Great Recession 2.0 anytime soon.*** The most likely driver of inflated asset prices in the current environment is central bank activity (ZIRP, asset purchases, etc), the effects of which are far more widespread than just the stock market. Barring any dramatic changes on the horizon in other asset classes or inflation, the freely available information regarding the nature of policies, and central bankers penchant for deliberate and widely telegraphed actions, it’s hard to believe there will be a dramatic devaluation.

Postscript

While we can all acknowledge that Beanie Babies aren’t worth much more than their sale price regardless of their rarity, to this day they still sell for thousands of dollars. Money laundering? Some other nefarious scheme? The world may never know. The point is that they still retain at least some value. At the end of bubbles, all assets return to a widely accepted fair value.

 

 

 

Disclosures (23 Jan 2018):

* I’m long Amazon stock.

** I don’t currently have any positions in cryptocurrencies.

*** I’m long stocks in general. This is my opinion and not investment advice obviously.

 

 

Featured Image by Vita Marija Murenaite on Unsplash

Oil and Gold Update

Friday’s 3% drop in crude oil definitively broke below $50/barrel with open interest for WTI (as reported in the COT Report) at all time highs. Headlines cite lessening concerns regarding Tropical Storm Nate and oversupply issues. Volatility remains subdued though ahead of OPEC’s Monthly Oil Market Report on Weds followed by the IEA’s report on Thurs.

The WTI COT Report also shows that Producers – who have a natural bias to be short – haven’t been net short this little since Jan 2015 (AKA their net position, while still short, is the longest it’s been in awhile). In Brent, the Money Mangers’ net position is the shortest it’s been in our data’s history (dating back to 2008).

Funny trade in gold on Friday as well – expiring over a year from now the following trade was blocked – all new positioning:

– 7,500 Dec18 2000 calls @ 3
– 7,500 Dec18 2600 calls @ 0.15
– 15,000 Dec18 3000 calls @ 0.1

The sizes make it look like a call spread stupid (the 2000-3000 call spread WITH the 2600-3000 call spread) for when the SHTF – but that far out both in strike and expiry, who knows.

Market Update

This week starts with Jackson Hole behind us, Hurricane Harvey still playing out, and NFPs/debt ceiling concerns looming on the horizon. S&P500 ATM volatility (and put skew) has come back down to earth in spite of realized vol creeping higher while the dollar index is at the lowest level it’s seen since Jan 2016.

Energy

As of Sunday evening, according to the WSJ Hurricane Harvey has taken out ~15% of the US’ oil refining capacity as it continues its destruction and energy markets prepare for a bumpy week. WTI futures are pivoting around the new year although gasoline (RBOB) futures could end up being the more interesting story having caught a pure bid with front contracts up 5.8%:
WTI
RBOB

Gold

Thus far in 2017 gold has been unable to break $1,300 although not for lack of trying. With spot prices threatening the high-water mark again the COT report shows that managed money (AKA speculators) have reduced their short positions to the lowest absolute level since mid-Dec 2012:
Gold
Dec 2012 started a ~40% decline in gold prices so YMMV.
Longer dated constant maturity vols are near recent lows, while 7-day CM vol is hovering around average on a 1-year timeline so it appears that the market isn’t setup for any long-term surprises (with the exception of the occasional volume spike like the one on Friday ahead of Yellen’s speech):
Gold Vol Cone
Gold Volume Spike

Cross Asset Class Volatility Update

In the last few weeks volatility has returned to financial headlines with a vengeance leaving traders checking under their beds for asset bubbles and causing “panic” when VIX traded with a 17-handle for the first time since November 2016. So what’s really playing out in markets?

* note that the volatilities shown are calculated using industry standards based on the type of asset; for example, absolute levels cannot be compared between rates and metals.

Rates

In rates space historical volatility (orange) has picked up but implieds (blue) are lackadaisical. FV/5-yr, TY/10-yr, and US/bond, 30-day constant maturity series are shown respectively below:

 

Here’s a longer dated TY history:

Metals

Gold vol has actually found a bid (with silver and palladium following suit):

While platinum, thus far, is flat:

Energy

Natural Gas implied volatility is the lowest it’s been since 2014:

Although oil is off the lows of the year:

Ags

Vol has come back down in grains after an exciting month although wheat could be picking up again:

Equities

And last but not least, E-mini S&P500 vol has caught a bid:

For a little perspective of where we are currently, here’s a 5-year history of a few constant maturity series:

Like all things, low vol environments eventually come to an end, but low vol by itself doesn’t “trigger”  eruptions. Claiming that vol can uptick ahead of an event isn’t exactly going out on a limb. But I’m sure they’ll tell you they told you so next week.

Our CEO Nick Howard joins The Futures Options Roundtable once again…

“One thing that I think the people out there that are trading options might forget now is that the CME has the weeklies that are listed. The weeklies are going to tend to give you a pretty good idea of what people are thinking in the short term.”

This was one of many insights from Nick during the hour-long podcast hosted by Mark Longo, founder of The Options Insider. The rest of panel included Matthew Bradbard, vice president of managed futures and alternatives at RCM Asset Management, Dan Collins, editor-in-chief of Futures Magazine, Dan Cook, director of business development at Nadex and Jeff Lewandowski, analyst at Protean Trading.

Brent-crude-vol-skewDuring this edition of The Futures Options Roundtable, the panel discussed the Commodity Sturm Ung Drang Grand Marketplace, most notably volatility in the crude oil/energy markets, the affects of the recent situation in Iraq on the oil markets and the changing volatility of gold in past months. Longo rounded out the conversation by prompting his guests with a series of questions from his listeners.

To listen to the entire podcast, follow this link: ow.ly/z0Lww.