The Wave Paradox

Are we trading reality or creating the reality that we're trading?
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Right, so I've got a theory I like to call the "wave paradox."

Maybe it's nonsense, maybe it's got some merit, but whatever the case, it's starting to seem like a lot of ostensibly "smart" folks are expressing the same idea only using less colorful language than I typically employ.

The concept is simple: market participants of all stripes are no longer able to discern whether they are capitalizing off the prevailing dynamic or creating the dynamic that they're capitalizing on.

This can be posed as a question: "Am I making good decisions or are the decisions I'm making only turning out good by virtue of my having made them?"

That might sound like the worst kind of tautological bullshit, but it's not.

If the former is true (that is, you made a good decision by getting long an asset that subsequently appreciated in value), then the fate of that asset going forward is largely independent of what you do next.

If the latter is true (that is, your decision to get long an asset was a non-trivial part of why that asset subsequently appreciated in value), then the fate of that asset going forward is in part contingent upon what you do next.

Obviously, this dynamic is always present in markets - more buying than selling or more selling than buying, etc. And it is of course readily observable in individual stocks when a heavyweight (say a hedge fund) bullies shares around. But currently, this is taking place at the aggregate level. That is, the entire market is subject to this phenomenon. And everyone from the whales to the minnows are unwittingly participating in it.

For instance, Norway's $950 billion-ish sovereign wealth fund (the largest on the planet) seems to have lost track of whether they're riding the wave or creating the wave they're riding.

“We don’t have any views on whether the market is priced high or low, whether bonds and stocks are expensive or cheap,” Trond Grande, the fund’s deputy chief executive said recently.

Well Trond, that's interesting considering the fact Norway is getting ready to up the fund's equity allocation to 70%, a level that's probably more appropriate for a twenty-something bartender looking to invest his first $10,000 than it is for the world's largest piggy bank. The one that is supposed to safeguard Norway's oil wealth for future generations.

If you look at what's behind the allocation decision it's clear what Norway is doing: they started making withdrawals from the fund last year to plug budget gaps created by the downturn in crude prices and with returns suppressed by low rates on the fixed income side, they're simply trying to juice profits by buying more stocks. Then they're arming ol' Trond with a bunch of amorphous aphorisms that sound like they walked out of a market-themed Barnes & Noble calendar, and trotting him out to reassure the world that Norway isn't getting reckless.

Bottom line: clearly Norway "has a view" on where stocks are going and while it's probably true that they think equities have room to appreciate further based on how expensive bonds are, if you're managing nearly $1 trillion and your equity allocation is 70%, it would be easy to mistake the impact of your own investment decisions for evidence that those decisions were good ones.

Meanwhile, Japan - via the BoJ's lunatic ETF buying program which has saddled the bank with a cartoonish JPY16 trillion equity book - is quite literally printing money to ensure the value of shares they bought with money they also printed doesn't fall. And no, there are no typos in there. Again, it's the same dynamic: they're riding a wave that they're creating. On the "bright" side, it seems likely that at least the BoJ understands their own role in inflating the value of the shares they own.

Those mammoths, along with the ECB's ongoing purchases and the Fed's reinvestments are serving to push risk assets ever higher. Meanwhile, ETFs took in $245 billion in H1. As Deutsche Bank observed last month, "that would be the second largest full year for ETP inflows, just behind 2016 when the record was set at $283 billion for the full year figure [and yet] there is still one full half ahead, which usually tends to be the strongest one."

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(Deutsche Bank)

A big part of the reason you're seeing those inflows has to do with the wave dynamic. Investors think they're getting in on the action, but the herding facilitated by ETFs is actually helping to create the wave.

"A growing number of institutional managers, from Oaktree to Elliott to Bridgewater, have recently been expressing concerns not only about elevated valuations and the potential for a correction, but in many cases also about the potential for herding and the risk that markets have grown one-sided," Citi's Matt King wrote, in a note out Friday, before adding that "around $500 billion has flowed away from active managers and into ETFs over the past 12 months alone in equities where ETFs now account for over one-quarter of markets' traded volume."

The irony there, of course, is that institutions and mutual funds, at a loss for ideas on how to generate alpha in an environment where the wave dynamic ensures that benchmarks rise inexorably, are simply overweighting whatever sectors and stocks are driving the benchmarks. Have a look at this:

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(Goldman)

As Goldman explains, "Information Technology has been the primary driver of above-average fund returns versus their benchmarks in 2017 with the average large-cap mutual fund overweight Info Tech by 144 bp, the largest overweight across all sectors."

It's the same thing with hedge funds. Look at the sector tilt to Info Tech:

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(Goldman)

The problem with that is that it simply makes the wave bigger. And in doing so, it drives down volatility on the stocks that are driving up benchmarks and creates more momentum for those same shares.

Well, "there's an ETF for that" when it comes to low volatility and momentum, and suddenly, the very same stocks are getting even more money thrown at them by investors plowing cash into low volatility and momentum ETFs which, in some cases, are seeing their exposure to Info Tech rise at alarming rates.

"The combination of global credit growth and QE has created such a sustained bull market in many asset classes that investors are inevitably concluding that their best trade is simply to close their eyes and go long the market in the cheapest way possible," the above-mentioned Matt King goes on to write, in the same note mentioned above. "ETFs in principle offer a panoply of potentially uncorrelated factors, but in practice trading volumes have been overwhelmingly concentrated on the major indices."

See the problem here? No one seems to grasp their own role in creating the prevailing dynamic. This is no longer a two-way market.

Here is the key point: The idea that nothing too bad will happen when sentiment reverses rests on the possibly dubious assumption that what has become a one-way market on the way up will miraculously revert to a two-way market on the way down.

Y'all don't know about Heisenberg? Well you're about to because he'll be posting here from time to time when he's not busy over at his own spot: HeisenbergReport.com.

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