Get Out the Way of This Freight Train
Friday, 20 November 2020
By James Woodburn
[4 min read]
- Be ready for a potential sell-off
- The elusive edge
- Freight train ahead?
And back to cash we go…
At exactly 11:59am yesterday here’s the text I received from Chewbakker’s algorithm:
It’s the third time we’ve switched back into cash in three weeks.
What’s that telling us about the markets? Is it telling us a crash is coming?
You’ll find out in a second.
But first, the mailbag has been quiet lately. Are you still there? Are you still reading?
We hope so! Let us know. Let us know what you think about this, too…
We are heading into the final month of the year. And it’s the time of the year when you start to look back and reflect. In this spirit, Greg and I thought it would be useful to conduct a performance review of all our services.
We’re thinking we could create a scorecard for each service so you can see what did well and what lagged. It could be a useful exercise.
Tell us what you think! Reply to firstname.lastname@example.org.
Now, what’s going on in the markets?
Be ready for a potential sell-off
We’re in a weird time right now. That’s pointing out the obvious what with COVID and, well, 2020 in general!
But I’m talking specifically about what Chewbakker’s algo is telling us:
- Longer-term economic indicators are looking strong
- Yet the short-term indicators are raising loud alarm bells
What do I mean by that?
Here’s how Chewie explained it to me…
‘The algorithm has scanned the markets. It’s determined the risk is increasing. As such, we are changing to no allocation: 100% cash.
‘Why? The main reason why the algorithm moves to more risk-off is that the probability of a sell-off is high as the VVIX, the VIX of the VIX, is moving steadily higher.
‘At the same time, the Industrial Activity Indicator is all Green. This combination doesn’t happen a lot, but, when it happened in the past, in most of the cases, a sell-off ensued. If this is not the case, we will go back into Bonds and Equities when the algo give us the all-clear.
‘Remember, no position is also a position.’
OK, a little to unpack there. But it’s actually simple.
The algo Chewbakker’s developed derives its signal from the interplay of the gold and copper ratio, which measures long-term global economic health — and how market makers hedge their positions so that they are not exposed to market moves.
Let me just explain the latter, because this is what makes Chewbakker’s system unique.
The elusive edge
You may have heard of market makers. They are usually big investment banks. As the name suggests they facilitate liquidity by ‘making a market’ in certain financial products, like ETFs.
It’s a good business to be in, if you know how to manage risk.
Market makers have figured out that if prices stay within a given ‘normal’ range (usually around 2% up or down), they’ll make money. Exactly how they do this is complicated and doesn’t really matter to us here.
What does matter is what the market makers do when prices start moving outside this ‘normal’ range.
As I said, their main job is to manage risk. So, when prices move outside of their expected range, they start hedging their positions using options on something called the VVIX (which, as Chewie explained above, is the VIX of the VIX, or volatility of volatility).
Effectively, this is an expression of the premium the market makers pay to hedge their positions.
Remember, market makers provide a liquidity service and get paid nicely for it. They don’t want to be long or short the market. They have to be neutral at all times. Sometimes, it costs a lot to remain neutral. The higher these costs (premiums) are, the more stress there is within the market.
So, when the algo detects that this market stress is going higher, does that mean there’s a crash coming?
Sometimes. Sometimes not.
The aim of the algo is not to try and predict outcomes, but to find signals that tell us where our money is best placed at any given moment in time.
Rising stress in the markets means we’d likely be better off outside the stock market, until stress declines. That’s it.
That might sound complex. But it’s not. It’s actually quite simple.
What it comes down to for us is if we monitor hedging activity, we can start to understand when stress in the market is building.
Even better, we can see this very quickly and clearly.
It’s a near-instant signal. As soon as prices start moving outside of that normal range, we’ll see options in the VVIX start moving.
Figuring this out was Chewie’s big breakthrough.
Because — when combined with the copper-gold ratio — he found he could generate a very clear picture of what’s going on in the wider economy and the financial markets.
Which brings us back to the latest signal to go 100% cash…
Freight train ahead?
Right now, the market makers are paying more to protect their positions and de-risk their market exposure.
That’s telling us short-term risk is high, as Chewie explains…
‘It is almost 18% more expensive than usual for the market makers to hedge themselves against the risk in the markets.
‘In the past weeks the Risk Premium went from flat to 40%, back to 10%, back to 50% and now 18%. In normal times it doesn’t move this fast.
‘Our stress gauge went back to the stress zone: it is now 56%, up from last week when we were at 53%.
‘The Industrial Activity indicator, as expressed by the calculated ratio of Copper and Gold, is about the same as last week: Green. To be exact: we stayed in Excellent Economic Activity. The computed ratio is 100% out of a possible 100%.
‘So, all in all, the algorithm sees this contradiction: healthy economy indicated by the low copper/gold ratio. But too much stress for this state of economic abundance. Hence: we get out of the way of the freight train that might be around the bend!’
Of course, the freight train might not come.
But do you want to find out when your capital is sat on the tracks?
I remember the same signal appeared on 16 October.
I thought it was strange at the time. I was 100% shares, and they were still edging up.
But I listened to the system and moved to cash.
Then look what happened:
Source: Google Finance
Who knows what this latest signal means?
Time will tell.
One thing’s for sure: it’ll be a stress-free wait.
It’s like Chewie concluded:
‘In the long run, we will do better with less volatility in your account, less stress and more time to do other things!’
If you want to learn more about this awesome system we’ve been developing with Chewie, we are now ready to show you! Learn more below…
Have a great weekend.