What's up Reality Check?

Two simple words with a very impactful meaning: reality check. That is what dumb and smart investors experienced on Thursday when the indexes tanked -6%, but mostly the retail investors. (Graphic 1) Before Thursday, optimism was at all-time-highs, the market rebounded to its former highs, and the put/call ratio was at its lows (calls outnumbered puts). (Graphic 2) What caused the drop? A resurgence in new COVID-19 cases (mostly caused by states reopening too early and the recent protests)(Graphic 3), jobless claims still increasing by 1,542,000 (total of 29,505,027 for the week ending May 23), President Trump losing control of the social, political, and economical environment in the US (Graphic 4), and THE CORRECTION WAS LONG OVERDUE. The National Bureau of Economic Research determined that the peak (which marks the end of the expansion and the beginning of a recession) in monthly economic activity occurred in February 2020. (Graphic 5) What we are in is called a recession (and soon to be a depression), where volatility is high, and market-swings are frequent. What will happen is: as more economic data is released (painting a dark, ugly picture of our economy), the stock market will behave more correlated to that information. We will retest the previous lows and we may drop further. Volatility is back!!

Dear Reader,

The Market.

• The current responses from the Feds are more rapid than previous economic recessions. (Graphic 6 and Graphic 7)
• “There have been 144 rate cuts this year and I have lost track of how many QE announcements. Aggregate rate cuts total over 50% which is bigger than the 31.5% of rate cuts in 2019 — itself a big year of monetary policy easing. After many years of investing, I think this and watching the inflation numbers that help drive it are about the most important thing I can watch.”
• “The pandemic somehow turned a bunch of people into day traders”.
• “While we do expect a continued surge in hiring in the coming months, the need for continued physical distancing well into the future suggests there will still be lingering damage in some industries, with the unemployment rate remaining elevated for years,” said Capital Economics senior U.S. economist Michael Pearce.
• The cycle we are in: 1) high levels of indebtedness and extremely low-interest rates, which limits central banks’ powers to stimulate the economy, 2) large wealth gaps and political divisions within countries, which leads to increased social and political conflicts, and 3) a rising world power (China) challenging the overextended existing world power (the US), which causes external conflict. (Ray Dalio)
• Sellers don't surge so much as buyers merely stop buying at the top of markets, and the reverse is true at the bottom of markets.
• “We can’t shut down the economy again” Mnuchin
• The US Federal Reserve has two congressionally mandated objectives: maximum employment and stable prices.
• The Feds practically nationalized debt markets. Will the equity markets be next? (Graphic 8)

Current Risks.

• Global supply chains closing/being further delayed
• Risk-appetite increasing to unsustainable levels
• Liquidity issues
• Solvency issues
• Risks to globalization
• Rise of protectionism

Current Questions.

• Will there be a second COVID wave?
• How long will QE continue, and will it hold up?
• Will the newly added liquidity in the markets cushion the stock market fall?
• Is this a bear market rally?
• Who will be bailed out next?
• Where can investors get yield when interest rates are low and are expected to stay near zero, inflation is expected to rise in the future, emerging markets are debt-ridden, and deglobalization may occur?

“Weaker demand and significantly lower oil prices are holding down consumer price inflation.” - FOMC Statement 
 
For the third day in a row, the market has shown losses across the board following the Fed’s monetary decision. Here were the key takeaways.

• Will maintain the target range for the federal funds rate at 0 to 1/4 percent until at least 2022.
• Will keep a maximum employment objective and its symmetric 2 percent inflation objective.
• Federal Reserve will increase its holdings of Treasury securities and agency residential and commercial mortgage-backed securities. 
• Powell notes a ‘high level of uncertainty’ citing the coronavirus. 
• Fed warned of a “long road” to economic recovery with Chairmen Powell stating, “This is going to take some time”
• The Fed expects the economy to shrink 6.5% this year and the unemployment rate to be 9.3%, before falling to 6.5% in 2021.
• 2021 economic forecast is for the fastest pace of growth since Ronald Reagan was president. (See the high and low ends of Graphic 9 and Graphic 10)

 
“The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.” - FOMC Statement 
 
The Fed has many tools at its disposal but quantitative easing, yield curve control, and setting the federal funds rate are the most widely discussed and used tools today. Quantitative easing and yield curve control both involve pushing out or creating money to buy bonds. QE is when the Fed injects liquidity into the system through the massive purchase of bonds on the open market. In doing so they intentionally bid up the prices of bonds and reduce long term interest rates and borrowing costs. Yield curve control is when the Fed sets a long-term interest rate target and buys as many long term bonds as it needs to achieve that target. This is different than simply setting the federal funds rate. Proponents of the using yield curve control argue that the Fed can achieve lower interest rates with a smaller balance sheet than with QE. This would allow the Fed to not exhaust its resources and therefore be able to turn to other tools if needed. With the Fed balance sheet at $7.2 trillion yield curve control may allow the Fed to stimulate the economy while keeping a relatively low balance sheet if bringing the short term rates to zero is not enough. 

​Options Theta -  Time Decay
 
Theta, or how I learned to hate time decay. Theta is a first-order effect measuring the decrease in the options price due to time. This effect is usually called time decay, as the options price decays as it gets closer to expiry. When buying options, this usually has the most detrimental effect on a stagnating stock price, as it always exhibits negative properties. While it is a burden when buying options, the reverse holds true while writing options. An options price has two main value components, its intrinsic value, and the time value. The intrinsic value is the current amount the option is in the money or above/below the strike price. The time value is the rest of the price, which is the time left for the potential option to get further in the money, or just become profitable. With this added time value, it is almost always more profitable to not exercise an option early. This however does not mean its a bad idea to lock-in the current gain by offsetting the position or selling the option in the market.

Smart Money vs. Dumb Money

In the bluntest way possible, "smart money" is exactly what you would expect it to be. It's capital injected into the market by "smart" people. What determines a "smart" person when it comes to investing? Anyone in any organization with some sort of track record or respect. The trading desk at Citibank, a mutual fund, a hedge fund, Warren Buffet, Ray Dalio, and the list goes on. People or corporations with experience, special analytical skills, and perhaps some industry information not available to most ordinary people (edge). "Dumb Money" is made up of everyone else (retail investors). You, me, my dad, my third cousin, my neighbor Jerry. We're just retail investors that do not have access to large amounts of data, nor do most of us have the time, skill, and drive to match the analysis of these large institutions.  Any move made by an institutional investor is considered smart money.
But should it be?
There is little evidence that shows institutional investors, people whose investments would be deemed "smart money", are performing better than the other "dummies". Over the past 15 years, less than 10% of hedge fund managers beat the S&P 500. So, my neighbor Jerry can park most of his money in an index like the S&P, and then play around with some smaller trades on the side. Barring any extreme circumstances, Jerry's portfolio/401k is going to outperform a hedge fund any given year (except the Renaissance Fund, but that’s not fair).
It's also important to remember that smart money investors have some systematic advantages. Institutional investors represent over 70% of the market investments. Some corporations are trading with billion-dollar portfolios. The sheer volume of capital is enough to push prices in their positional direction. Moreover, they have the advantage of being viewed as "smart". Any trader from J.P. Morgan can write a piece on some stock saying how it’s a great buy. They can use some figures they pulled off a Bloomberg terminal (with a cost of tens of thousands of dollars per month), and convince some less Finance-savvy folks to listen to them. After all, they work for a giant bank and have connections with market mavens (people that are "in the know"). So we should listen to them, right? Not exactly. If they write a piece on XYZ stock, people will see it and then decide to buy it, thinking that since this analyst wrote about it, it must be good. The influx of capital from people buying the stock solely based on the article is enough to push the price of the stock up, thus making the article predictions come true. It is a self-fulfilling prophecy. Maybe XYZ stock is truly a great buy. But be wary of anyone that tells you they know for certain that this stock is the next big thing. They're trying to convince themselves just as much as they're trying to convince you. Then, there's the whole issue with banks engaging in market manipulation. Purposely releasing information to the public to drive prices up so they can unload their bad investments at a profit (looking at you, JPM). They'll stay stuff like "This stock is an automatic buy at this price" or "The sell-off has gone long enough".

​Case Study:
On August 20th, 2019, JP Morgan upgraded Beyond Meat ($BYND) to a "BUY". This is purely hypothetical: They probably did this because they were riding the ridiculous climb of the company, one in which was easy to tell is a farce if looking at any analytical figure. Once the stock started to fall, they realized they needed to exit. So they released information to pump the price, and once it got above their average cost/desired profit point, they sold. Once they released their upgrade, the stock popped 14% on the next trading day. That pop lasted all of two weeks before plummeting further.
The takeaway here: Do your own Due Diligence. Don’t listen to advice simply because it comes from someone deemed by society to be "smart".