I am finding macro hard to trade right now, and hedge prices suggest I am not alone. Three weeks out from a US Presidential Election, it is unusual to be at ATHs in stocks, yet part of the reason for the ongoing drive higher is that it is un-owned (or at least well hedged): VIX has stubbornly remained above 20, indicating a good amount of discomfort, yet as that vol fails to realise we’re seeing pressure to ‘stop in’ to long risk on any dip.
August had something to do with this: Short vol trades were materially hurt in the early August de-grossing, so the typical pre-Election de-risking had already taken place. Yet there are also a number of known factors in focus, any of which could induce fear in markets. The problem is, trading risk factors without catalysts is the definition of sloppy, and your returns are eaten up by hedges.
When traders consider their (low) risk exposure, none would admit (out loud) to ‘a pricking of their thumbs’ in creating discomfort, yet of our four risk-factor buckets the ‘unknown unknown’ area is the largest by an infinite degree. That doesn’t mean it’s responsible or clever to talk about it, and it wouldn’t carry much weight in a letter to investors. Nevertheless, this bucket represents humility:
F1: Breaking down knowns and unknows, the red box is infinite in size…
Briefly looking at the McKinsey-esque 2x2 above, the green box really only contains the risk-free rate… and even that has been challenged by recent fiscal intransigence. Most market themes are orange or blue: We may know the information, but be unsure how much it will impact the market (orange); or be unsure of the information, but have a bounded risk expression. The red box is infinite in size, but probabilities decrease as we move from the middle, so we don’t spend much time on it for fear of analysis paralysis.
As a friend told me recently, “there can be a 2σ event tomorrow which wipes us all out, so you might as well get on with things you can control.” This is certainly correct, but when markets trade as perfectly as they do right now, it’s hard to shake that thumb pricking, which represents the humility that an infinitely large red box is there.
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