When disbelief meets complacency

Photo by Abed Ismail on Unsplash

As we write this note, markets stand very much at the precipice: the bellwethers of the global markets, namely the two major US indices, are off their recent all-time highs, with the NASDAQ firmly declared by most brokers to be in correction territory.

Undeniably, there remains a marked degree of complacency in the markets. The orthodoxy of “the markets eventually always go up” continues to be peddled by many pundits (how else would they have a job?), coloured by the “experience” of the past decade, and most notably the past 2 years. “Imagine you’d bought the lows in March 2020 – you’d be rich now”, goes the narrative.

We’ve always tried to look at markets objectively and play the game that is set before us as best we can. On one hand, one could say that we’re implicitly optimistic: after all, if we truly believed that the world was heading for the apocalypse, why would we be in the business of investing in the future? We very much enjoy taking on short positions, but the math of making a maximum of -100% on a short only has that much profitability in store for short sellers – notwithstanding the intellectual satisfaction of betting against consensus and winning.

We, too, are optimists, implicit in the choice of our trade. Conviction in a belief is also important. But as we’ve written many times before, no positions and beliefs are sacrosanct to the point where investor capital is sacrificed.

The game is changing, and the fastest way to lose is to keep playing the wrong meta.

And no, this has nothing to do with metaverses.

Though sometimes it’d be too easy to believe that we’re living in one.

Trading the metagame

A couple of weeks ago we linked to a blog post by Crypto OG Cobie entitled Trading the metagame. For those who haven’t read it, or for those who don’t spend time in gaming circles, the idea of the “metagame” might not make that much sense. Ironically, it is probably the most important thing that needs to be understood in markets.

The prefix “meta” comes from Greek, meaning “with, beyond, after” depending on the context used. This short snippet from Yes, Prime Minister is an old favourite in when it comes to attempts to explain “meta”. In the case of games, the metagame describes the big picture set of rules that govern how the game is played: the balance between different character types, weapons, items, spells and strategies.

There was once a generation of games in which the “metagame” doesn’t ever change: think of board games like Monopoly, Scrabble or even Chess. The rules are fixed, and while the strategies to win may be plenty in number, they follow the same principle.

Then came computer games, especially those that could be updated – first with manually installed patches, then instantaneously over the internet. This meant that developers could modify the dynamics of the game on the fly – ostensibly in the interests of keeping the game fresh and interesting, ensuring that no single strategy could hold dominance in the game and make it boring, hence the terms “buff” (to make stronger), “debuff” (to undo a buff) and “nerf” (to take an advantage away/make weaker).

Great, this is all very interesting, but how does this relate to the ongoing turbulence in traditional markets? Like it or not, even the world of traditional equities, stocks and bonds has evolved into a game where the rules can change.

We’ve written many times about how that has informed our process, compelling us to take into account factors like hedging flows, passive flows, retail, options expiry etc. when making decisions, rather than just accounting for “fundamentals” as we were traditionally taught to.

In a way, these are “minor” buffs/nerfs, to borrow the gaming terminology: the nature of the game has been slightly modified, not by a developer sitting in the heavens (though one sometimes wonders if that could be the case), but by the structural evolution of market composition.

But the “metagame” hasn’t changed: “buy the dip” has been the metagame for more than a decade, ushering in great riches for those who simply held and kept adding, amassing huge assets in vehicles that take on strategies which are largely variations of the same idea.

From this, the complacency of “don’t worry, markets always go up (even in the short-ish term i.e. a couple of months)” has taken root.

All great, until the metagame starts to change – as it appears to be doing now.

Politics, The Fed and disbelief

When widespread complacency meets up with bewildered disbelief, things start going awry.

As we see it, the game that we’re all playing has just released a major patch: inflation is a problem – a political problem at that – and whatever you believe about central bank independence can go back to where it belongs (on an academic’s bookshelf). Politics rule, and pressure is building on the Fed to “do something” about widespread and elevated inflation which threatens to become entrenched.

The result: retiring the use of the word “transitory” when talking about inflation, then floating the idea of rate hikes, then even hinting in the equivalent of “developer release notes” the prospect of reducing the Fed’s balance sheet. Accompanying that, a good number of “leaks” from JP Morgan suggesting that even 6-7 rate hikes won’t hurt the economy, and comments to a similar tune from other Fed members in their passing comments, knowing full well that EVERY single word they utter is studied in minute detail.

There’s no such thing as a passing comment when it comes to this game – the only question that needs to be asked is the one asked by one of our most ardently followed writers, Ben Hunt.

“Why am I seeing this NOW?”

The metagame is being changed right before our eyes, and these are the signs of that change happening. It may change back – heaven forbid that the metagame becomes one of flipping between the Fed being generous and parsimonious at varying frequencies, creating a meta-metagame. But that’s for another time – for now, all this means is that the rate hikes ARE coming, liquidity IS tightening, because they’ve said so and they’re priming the market to that prospect.

The problem is that the market doesn’t believe it.

Not yet.

Groundhog day?

Unfortunately we don’t have a crystal ball that tells the future, but by the time this newsletter makes the rounds, the situation we’d all be in is as follows: major US indices significantly off highs, just at the end of an options expiration day.

When Monday comes along, as the options gang will say, dealer gamma would have fallen off after expiry (Friday), and the markets are free to move in whatever direction they choose, without a gamma pin.

Over the past two years, unpinning markets often meant “numba go up”. Most of this underpin came from a solid wave of passive money flowing into the market, buying where active sellers sold. This continues to be the case – as it was between Feb and March 2020. But passive is slow, and gamma – as we also learnt in 2020 – goes from positive, to zero, to negative.

And when dealer gamma is negative, things can get violent quickly. Especially when amongst the many other issues to watch out for, there’s also the matter of spot market liquidity relative to the size of the derivatives notional that is being traded – something discussed in this podcast with Cem Karsan.

This is why we now find ourselves at a precipice: maybe things bounce back up, maybe they go for a ride down, but whatever the market chooses, given this set up, it will most likely be fast and furious.

And to be caught on the wrong side of this trade will be very painful.

One final note on crypto markets, since that’s where the metagame analogy came from (yes, TradFi can learn from crypto traders too!): THAT metagame has also changed. It would be foolish to think for one moment that for any reason, the structural growth opportunities in crypto will insulate it from the movements in the equity markets.

Crypto’s metagame, too, has changed: the arrival of the institutions means the commingling of behaviour at the interface of two hitherto distinct worlds. That interface is the price of BTC and ETH, and the reality is that for everyone in crypto, you may not care what the Fed does, but would definitely care about what BTC and ETH do. Turns out the Fed has an impact on BTC and ETH, because the people who care about the Fed are the marginal traders in BTC and ETH.

Whatever your cup of tea is when it comes to markets, stay safe, good luck and (if possible) have fun.