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The 10th Man: When the Market Moves Fast, Stuff Blows Up


 -- Published: Thursday, 11 December 2014 | Print  | Disqus 

By Jared Dillian 

One of my old rules of trading is that whenever a major asset class, index, or other benchmark has a sudden, rapid move in price, something blows up. Sky high.

Thatís because people get used to regimes. They get used to a certain state of affairs with a lack of volatility. They become complacent. Maybe they stop hedging. Maybe they allow themselves to have unbounded downside risk. Maybe they start gambling.

In the last month, weíve seen massive moves in the dollar and oilóand I assure you, someone is going to get hurt.

So far I havenít said anything controversial. Energy companies are going to get hurt by lower oil prices. Exporters are going to get hurt by a rising dollar. A chimpanzee could figure this out.

But there are second-order effects. People are starting to figure out that Canadian banks are going to get hurt by the lack of investment banking business from the energy sector, and the stocks are getting punished.

And there are third-order effects too, which people will soon discover.

If you sit around and think hard enough, you can make these sorts of connections. Some people are very good at this. A commodity price moves fast, and they can figure out the point of maximum pain for some company far down the supply chain from the actual commodity.

Iím not that smart. But Iím smart enough to get out of the way when something big and important like oil moves 40%.

Letís step into our time machine and set the dial to 1994. That was the year when interest rates backed up a couple of percentage points. Remember the bond market vigilantes? They were pricing in Hillarycare and a Democratic Party wish list, and they caned the bond market until interest rates were making borrowers squeal.

But what was interesting about 1994 was that in the grand scheme of things, interest rates didnít go up all that much. Just a couple of percentage points. Now, if I asked you who you thought would get hurt by rising rates, you might say banks, hedge funds. And you would be wrong. Who got hurt by rising interest rates?

Procter & Gamble.

Orange County, CA.

Mexico.

Why did the first two blow up? Derivatives.

By the way, Iím not referring to derivatives pejoratively. Iíve spent most of my adult life trading them. Theyíre not financial weapons of mass destruction. What they do is take risk over here and move it over there. So if bank XYZ was negatively exposed to higher interest rates, they were able to offset that exposure to Orange County through derivatives.

Of course, the derivatives Orange County was trading were very exotic and clearly unsuitable for a municipality, but thatís a discussion for another time over a burger and a beer. The point is that rates moved, and they moved fast, and stuff blew up.

But not the stuff you thought would blow up.

Buying Volatility on the Cheap

So I know what youíre going to ask me next: Whatís going to blow up?

Who knows? By definition, you canít know, especially when the risk has been laid off through derivatives.

But this is how it works: Oil moves 40%, the dollar moves 10-15%, and someoneís out of business. It could be someone big. It could be someone systemically important, someone that could really spook the markets. So when stuff like this happens, I get myself exposure to things that gain from disorder (paraphrasing Black Swan author Nassim Taleb).

With the S&P 500 Index (SPX) at 2,050 and the CBOEís Volatility Index (VIX) at about 15, systemic risk is vastly underpriced.

Iím not saying that stocks are too high, that Iím bearish. Iím just saying that the derivatives markets arenít pricing in what could be a big unwind based on these oil and dollar moves.

Translation: volatility is cheap.

Is $60 oil bullish for stocks, long term? Absolutely. It is one of the most bullish things I can think of. One of my clients recently told me that this decline in oil will result in $100,000 in annual fuel savings for his business. Multiply that times everyone. So bullish. And the dollar, also long-term bullish. But in the short term, thereís an Amaranth out there somewhere, potentially.

Maybe itís not a hedge fund. Maybe itís a company like Coca-Cola (KO) that gets the majority of its earnings from overseas. Maybe itís the railroads. The person who can figure this out wins the prize.

As I said before, Iím not that smartÖ just a former trader with scabs on his knuckles. But the funny thing about those tradersóespecially the ones over 40óis they have a nose for trouble. Iím all in favor of bullish developments, just not when they happen really fast and nobody is ready, which is how people get maimed.

Position: long three-month SPY puts, short Canadian Imperial Bank of Commerce (CM) and Toronto-Dominion Bank (TD) (the US-listed shares).

Jared Dillian
Jared Dillian


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 -- Published: Thursday, 11 December 2014 | E-Mail  | Print  | Source: GoldSeek.com

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