The 10th Man

It’s Time to Start Thinking about the Right Tail

May 14, 2020

Most of you know what a normal distribution is, and that it has a tail.

What many don’t know is that it actually has two tails.

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The logarithmic returns of stock prices are normally distributed, and most people spend their time worrying about the left tail—the likelihood that stocks will crash. A reasonable thing to worry about. After all, they just crashed.

And with stocks, the high-velocity moves are typically down. Markets don’t typically crash up.

There have been certain historical examples where stocks actually have crashed up. Usually because of high inflation or hyperinflation.

In the US, people obsess about when stocks will crash again and reach lower lows. I encourage you to think about the right tail as well—the probability that stocks will crash up.

They don’t even have to crash up—they just need to do what they’ve done for the last 10 years, which is go up about 19% a year.

Everyone is confused about the price action post-crisis. The economy is basically in a depression, yet stocks keep climbing higher.

It’s not that hard to figure out—the Federal Reserve is buying everything in sight. The Fed just started buying credit ETFs this week. With the Fed buying municipal bonds, investment grade corporate bonds, high-yield bonds, Treasuries, and mortgages, it’s kind of hard for the stock market to go down.

And if stocks did go down, I would fully expect the Fed to buy stocks, too.

The left tail has been made obsolete. It is time to start thinking about the right tail.

No Argument

As for the stock market, there should be no arguments here about being bullish or bearish. This isn’t a discussion about that. This is a matter of looking at the stock market as a mathematician would, dispassionately, only considering the probability distribution. And the distribution has effectively truncated the downside.

My friend Christopher Cole, the founder of Artemis Capital, was talking about the right tail of the distribution back in 2012. It was exactly the right time to be thinking about the right tail, since the S&P 500 almost tripled over the following eight years.

Could the S&P 500 triple again in the next eight years? Maybe.

Then there is the question of what you should do about it. It’s not simply a matter of being long stocks—everyone is long stocks, anyway.

Typically, when people express a trade like this, they do it in the form of long-dated risk reversals. A risk reversal is when you sell a put option at a lower strike, and buy a call option at a higher strike, using the longest-term options available. The strikes are very wide.

Note that this is an example, not a recommendation. This is a sophisticated investing strategy. If you are doing this on your own, do your due diligence before putting any money to work in this or any idea.

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Problem is, nobody is in the mood to sell crash puts, for reasons that should be obvious. But perhaps now is the time to sell crash puts.

I have been thinking of ways to do this in a limited risk fashion. But the nice thing about the risk reversal structure is that the sale of the put pays for the call premium, so you can put it on for free, or a small credit.

If you start spreading the put to the downside, you end up buying a very expensive option. And that is the nice thing about selling far downside puts these days—the skew is very steep, so you are being compensated for the risk.

The trouble with this trade, in my mind, isn’t really the P&L, but the fact that it’s not really a hedge. In fact, if stocks do crash, you will have plenty of other stuff to worry about, and the last thing you need is to be short a put that blows up in value.

And believe me, it would blow up in value. If anything, you should buy those puts, as a hedge, not sell them. So this structure only makes sense if your portfolio does not already have a large exposure to equities.

The Morality of It

Here, in the United States, we are obsessed with the stock market. After all, everyone’s retirement savings is in it. The government and the Fed, collectively, will never allow it to fail.

That is a very cynical thing to say, but it is true, and it only became apparent after a decade of observing that the reaction function of the Fed completely revolved around the stock market. If the S&P 500 fell 20% from here, there would be even more aggressive easing, up to and including negative interest rates and the Fed buying stocks.

Sometimes, I get pushback about central banks buying equities. People point to Japan, whose equity market is still down significantly from the highs. Yes, but it is significantly off the lows it reached in 2012, when Abenomics was implemented.

Don’t overthink this: If the Fed were to buy stocks, they would go up.

Again, we’re not going to get into what’s wrong or right. These are the parameters we have been given. You have to consider all possibilities, not just the ones the anti-Fed people talk about on Twitter. The irony is, of course, that if they thought a little more about what the Fed was doing, they might come to a different conclusion.

Music

I wanted to catch you up on some music stuff. I’ve published two new mixes in the last month: The Found and Fourth Moment 2. Hope you enjoy them!


Jared Dillian

 

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Comments

Thomas Majewski

May 16, 6:38 a.m.

Jared, I always like reading your articles even though I might not agree with everything.  We now have the Fed ready to bailout everything in sight no matter the cost.  To me this suggests the system has become entirely corrupt.  This is not true capitalism or the process of free markets in action. At what point does all this electronic money begin to be disintegrated by the corruption it is trying to mask over? Speaking of masks, never have worn one and not starting now.

If there are no limits to this kind of monetary backstopping, where is the integrity and balance of our financial system?  Why not make everyone a millionaire with electronic dollars?  The government continues to add debt as do corporations and consumers and yet there is virtually no inflation, well maybe not the 1970’s style of inflation. 

The option strategy is interesting but the time frame is crazy. With this increased volatility I’d rather trade options in the short term and go with the daily ups and downs.  What else is there to do being locked in a closet without a TV and no smart phone?

jack goldman

May 15, 10:03 a.m.

Jared, as a “10th Man” you should know better than to measure stocks by points. In points, the stocks can go up. But in real US Treasury gold eagle money, the stocks have been going DOWN for 54 years, down from 28 ounces of gold to 14 ounces to gold. What you are witnessing is the collapse of the debt note dollar, also known as “points”. You should know better. Points are illegally defined units of weights and measures with no legal definition. What is the difference between one debt note and one billion debt notes? Nine key strokes. It’s all just an illusion. Stocks are valued in gold for real value and in points for fake imaginary value. Points can be wiped out at any time. Houses, gardens, businesses remain intact. Points evaporate, wiped out. Civilization is playing a sick cruel joke on itself using illegally defined weights and measures like the debt note dollar. If you want the real story, measure the real world in gold, real money. Stocks are down from 44 ounces of gold in 2000 to 14 ounces of gold in 2020, DOWN 68% in real money. A real crash. But up from 10,000 points to 23,000 points. Nasdaq is up about 1% a year in points from 5,000 to 9,000, big deal. I think gold correctly reveals the fantasy land of fake internet businesses versus the real world of real money. Be a tenth man, not a soy boy. Measure reality in gold. Get it?

fred@portfoliodoc.com

May 14, 1:58 p.m.

Jared, better not let your buddy Chris Cole hear you talking about selling a crash put at a current market valuation rivaling 2000. He is liable to buy it from you.