The Nasdaq Whale
John Leiper – Chief Investment Officer – 7th September 2020
The ACUMEN Portfolios continue to perform well. As you can see from the table below, performance for the rolling quarter (to the end of August) remains strong relative to the market composite benchmark and the current assigned IA sector, which I understand many advisers use for comparison purposes. ACUMEN Portfolios 3-8 were all in the first quartile and ranked in the top 15 within their category.
Outperformance versus the IA sector is to a large extent driven by our currency overlay strategy which is positioned for a weaker US dollar. However, this does not explain performance relative to the market composite benchmark which is predominantly currency hedged and a higher bar to beat given it excludes fees and trading costs. Instead, this can be largely attributed to four key themes mentioned in prior blogs as well as our Quarterly Perspectives publication: inflation, emerging market equities, ESG and commodities. These themes comprise our longer-term strategic market outlook and asset allocation decisions which we have implemented across the funds via several active risk positions.
The portfolios have also benefited from exposure to US mega-cap stocks, typically referred to as the FAANGs, namely Facebook, Amazon, Apple, Netflix and Alphabet – formerly Google. These companies sit within the technology and consumer discretionary sectors which have rallied back to all-time highs, and then some, even as the remaining sectors of the S&P 500 and indeed the rest of the world excluding the US, remain approximately 7% below prior highs (when measured on an equal weighted basis).
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This notable and dramatic divergence in performance can be explained by the FAANGs perceived safe haven status, given high cash levels and a business model that is particularly suited to the coronavirus, and before that to a world of low inflation and low interest rates. Surging liquidity and the fear-of-missing-out further exacerbated this trend.
In The Bigger They Are The Harder They Fall we explained that, despite positive underlying fundamentals, valuations in this space had become extreme. At the time we showed that the top 5 companies in the S&P 500 (the FAANGs) represented over 22% of total market capitalisation which represented the highest market concentration in over 30 years. This concentration, in just a handful of names, is not healthy and points to narrowing market breadth, which has historically been a strong indicator of subsequent market drawdowns. As a result, we booked some profits by bringing our US tech position back to model weight. Later that month we booked additional profits, reducing the position further.
Fast forward to early September and some of our earlier misgivings seem to make sense. In an FT article published Friday, SoftBank has been unmasked as the mysterious ‘Nasdaq whale’ responsible for driving US tech stocks to extreme levels (before the sharp sell-off on Thursday and Friday last week) by buying billions of dollars’ worth of call options – ‘which give the user the right to buy a stock at a pre-agreed price’. The article refers to a number of sources who described SoftBank’s alleged actions as ‘huge’, ‘dangerous’ and ‘the largest ever trading volumes in contracts linked to individual companies’ on record.
Due to the dynamics around options trading, to hedge investment exposure, the counterparts to these trades will have bought stocks in the market. This creates a self-perpetuating feedback loop between Softbank buying call options and dealers buying stocks causing tech stocks to rise in price. This dynamic explains why implied volatility for the Nasdaq 100 had been rising throughout August even as the underlying index also rose in value. Simultaneous increases in both equity and volatility are unusual and can be a cause for concern.
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This is shown in the chart below which shows prior instances where volatility and equity index correlations have turned positive (bottom panel) and how this is consistent with periods of risk aversion in the index (white line).
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What goes up can come down, and the key risk is that if Softbank starts to unwind these trades, the feedback loop can easily turn negative. This is especially true for crowded trades and to that extent it is somewhat disconcerting to note that ‘long US tech and growth’ remains the most crowded trade, for the fourth consecutive month, according to the latest Bank of America fund manager survey. This is compounded by the rising number of retail investors also participating in the trade via online trading platforms such as Robinhood which offer commission free trading. Historically, when small traders become overly enthusiastic it typically signals a potential market top and impending correction.
One source, referenced in the article, expects SoftBank’s ‘buying to resume’ given the more damaging risk to the strategy from ‘a larger and longer-lasting stock market decline’. This makes sense but give the position is now public knowledge my concern is other players may look to exit as they realise prior gains were not broad based or sustainable in nature but rather short-term speculative market bets. At an extreme, this could also incentivise speculative short selling to try and squeeze SoftBank’s position, as speculators have someone to cover their positions.
Whatever the outcome, valuations have become distorted by the actions of one large player in the derivatives market. The market may well take this news in its stride, but these things rarely end well, and it is likely that US tech stocks could be entering a period of elevated volatility. Having pre-emptively reduced exposure to US technology we think the best strategy is to monitor the situation, remain cautious and continue to exercise our disciplined approach to risk management. If we do see a larger correction, we would view it as a healthy development and a potentially attractive opportunity for re-entry.
Key events impacting risk sentiment this week include ongoing trade negotiations between the UK and European Union, 10 and 30-year US bond auctions, Chinese and US inflation data and Thursday’s policy decision from the ECB.
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This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.
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