Pandemic Panic, Short Gamma, and Looking Forward
Updated: Mar 24, 2020
A lot has changed since my last blog post a few weeks ago. It has been somewhat surreal and it is clear we are living through historic times.
I wanted to begin with a mea culpa. In my last post, I did not have a full grasp of the severity of this pandemic in either a human or an economic sense. Comparing this event to the Spanish Flu and the 1987 market crash were decent analogies, but far from accurate; I could have done better.
So here we are. We’ve witnessed carnage in the markets not seen in decades. Price and yield dislocations have happened with stunning rapidity and magnitude. If you had been in the know early, like some Senators, perhaps you could have dodged the bullets. But few were, even among professional traders and investors. So what now? How do you make rational decisions about your portfolio going forward?
I’d like to begin by looking at a simple trade. Please bear with me.
Bond traders do what’s called the “Basis” trade. They buy a bond, sell a bond future, and pocket the price difference. Since bonds and bond futures should be priced almost exactly the same, where is the profit? If you buy a bond future, there are multiple bonds that can be delivered to you on expiry; the seller has the option to choose which bond. Options have value (it’s always nice to be able to choose) and in this case, while the option isn’t marketable, it does exist in the pricing of that future. So, when a bond trader gets “long” the basis, ie buys the bond and sells the future, the small price difference that she pockets is the option premium that has been sold.
An aside about trading nomenclature. Options are priced using volatility, a measure of price movement; when volatility goes up, option values rise. Short-term volatility is called Gamma (it’s a math variable). So, when a trader sells an option, it is called getting “short gamma.” Selling an option is exactly what insurance companies do when they write a policy on a car, home, etc. The insurance company is betting that across all it’s members, only a few will get into trouble at any one time, so the premiums they charge are greater than the claims they have to honor. That’s a great business when things are “normal,” but not so great when there is a storm. Short Gamma = Selling Insurance.
Bond traders are selling gamma (betting the world will be “normal”) when they do the basis trade. Since the profit is small, why do it? Leverage. Because of the way the financial rules were constructed after the 08-09 GFC, US Treasuries are considered “risk-free” on balance sheets; this enables traders to borrow lots of money to buy lots of bonds. Basis Profit = Leverage * (Bonds - Futures) - (the cost to borrow lots of bonds).
The mechanics work like this: Hedge fund A buys bonds and sells futures. It has the actual cash to buy 1 bond but buys 50. The next day, hedge fund A has to deliver cash to the seller of those 50 bonds. So, hedge fund A takes those 50 bonds and goes to the repo market, where it loans the bonds to someone (usually a bank), gets cash in return (to pay the bond seller) and then pays the cash lender a tiny bit each day for the use of their cash while the cash lender holds their bonds as collateral. Clear as mud?
Why does this matter now? In one simple word, cash. When things get hairy in the market, people want their cash. Banks start charging very high amounts for their cash in the repo market which makes the basis trade suddenly very, very unprofitable. When hedge fund A’s clients, sometimes very wealthy families or countries, sometimes in middle eastern oil-producing nations, call wanting to redeem their cash because oil prices have crashed, hedge fund A has to honor that request. Do they pull that cash from a strategy that has just lost a lot of money (the basis trade) where it might be hard to sell a lot of bonds quickly, or do they sell some of their stock holdings? They generally sell their stocks first because the stock market has the best liquidity in the world, then liquidate their basis / short-gamma strategy when they have to.
This forced selling, across multiple leveraged short-gamma strategies, has just taken place in the market. Did institutions make their decisions rationally based on the intrinsic value or forward expected return of the stocks they sold? No. They had to pay Vinnie the repo man. They had to give their clients their cash. They had to stay in business.
So, when odd things start happening in the market, like bonds going down the same day stocks do, or gold not acting as a hedge, you can bet that someone was forced to do something irrational to survive. Every financial disaster is basically the same story; a leveraged insurance seller is forced to pay very large claims because a storm hit (think LTCM, Bear Stearns, AIG, etc). And every fancy hedge fund strategy (Basis arbitrage, Statistical Arbitrage, Currency Carry, etc) are all just insurance selling wrapped up in fancy math to wow investors.
That’s a too-long explanation of where we are: the “Pandemic Panic” forced leveraged short-gamma players to act very irrationally. Most of the weak hands are now flushed out of the market; to paraphrase Buffett, the water is out and the naked people have run screaming from the pool.
As a long-term investor, the next questions should be: Was the initial panic justified? Have the long-term economic prospects for the US, and the World, changed permanently? Or, is this a temporary setback? And, where can I find value? (answer: almost everywhere).
This virus is serious. And as I mentioned in the beginning, far more serious than I understood initially. I can’t quantitatively speak to how it will impact the economy because the actions taken to contain the virus are unprecedented. I can say we will continue to see surreal numbers, like the upcoming jobless claims and the number of Covid-19 cases next week, so brace for impact.
To keep things in perspective, I looked at the below four plots (data is from the Johns Hopkins GitHub data set). On the left are the absolute number of Covid-19 cases and mortalities by country, on the right, those same numbers adjusted for population. In absolute terms, the US cases (and the growth rate) do not look good, but our mortality numbers (as sad as that is) are not that bad. In population-adjusted terms, we are doing well. The early actions to stop flights from Asia and Europe, in hindsight, now look like good decisions. Italy, looking at the data in either light, is becoming a humanitarian disaster. One grain of salt, the US needs to continue to ramp up our testing to improve our dataset; better data, better decisions.
Overall, things are not good, but perhaps not as terrible as the non-stop media coverage would have us believe. Could we as a country have done better? Absolutely. Are we doing enough now? I think so, but I am not an authority on epidemiology, so I can only hope and trust the experts. Could we find a way to beat this virus without dismantling our economy? I think we’ll figure that out and adjust.
Monetarily, the Fed and other Central Banks, have lowered interest rates and provided mind-boggling amounts of liquidity to the markets. Fiscally, the government is preparing financial aid packages that total in the Trillions (again, a surreal number). And on the health front, we’ve locked down major parts of the country and economy to flatten the spread of the virus, are ramping up our health care capacity, friends and family are headed to the health care front lines in ever-growing numbers (god bless!), private industry is making tests, PPE, and ventilators, anti-viral treatments are being tested, and vaccines are being worked on.
In short, the United States is waging a full-on three-front war against this virus.
My ability to predict the immediate future is terrible. The market could go up, down, sideways, and, as I said, brace for impact. Certainly, many assets are trading at discount prices, I cannot say when they will revert to their fair value, but now is the time to start hunting for bargains. In the long-term, things will improve. Will the world revert to how it was before? Probably not. Some aspects of our lives will actually improve, others, maybe not, we’ll find out as it unfolds. As a long-term investor, I would not bet against America.