Buy The Dip Or Run For The Hills? A Short Note On Risk Management.
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Time To Own Your Own Portfolio
by Alex King, CEO, Cestrian Capital Research, Inc
Nobody, not Warren Buffett, not Ken Griffin, not the guy posting the excellent Pepe memes on FinTwit, not you, not me, nobody knows whether the current selloff in risk assets is a brief correction or the beginning of a real bear market. Anyone that says they do know is lying, deluded, or both. Because what really causes sustained selling is … sustained selling. In other words, if sentiment moves to “you know what, I think I’ll just sell some stuff to be sure” or even further, to “crikey this is getting a bit worrisome, get me out”, or even “GET ME OUT NOW. RIGHT NOW. I SAID NOW”, then it is the snowball of compounding worry that keeps the bear moving. In bull markets, greed and FOMO drive the buying - I mean, in business school and kids’ comics they may tell you it’s earnings, to which I say, earnings lol. In bear markets, the desire to protect and FONGO (fear of not getting out) drive selling. Right now we have seen some dramatic selling which may be a dip or it may not.
So what does that mean right now for managing money, be it your fund’s money, your client assets under management, or your own money?
For me it means be careful - specifically it means reducing exposure, whether long or short, and it means being careful with leverage.
Leverage in its simplest form just means anything that has been amplified using debt. That could be leverage at the account level, or leverage within securities (like $TQQQ or $UVXY etc).
When problems hit the equity markets it usually starts out as a credit problem.
The financial crisis in 2008 was a credit problem, specifically an overextended mortgage market where everyone had agreed that if you wore a purplish-colored tie to work and looked at the relevant basket of loans from just the right angle, then magically BBB loans … looked just like AAA loans! Wow! And from there, once everyone realised that actually those things that looked like BBB, well, they were maybe not even that, because self-certification? Then the selling started. And got amplified and spread. And then it turned out that nobody quite knew who all the counterparties were in various OTC derivatives of those BB- er, sorry, AAA loan baskets. And then people started looking for the collateral that had been posted, only to find out that, well, there wasn’t any. And then got more scared. And sold more. And so on.
The Covid crisis in 2020 was also a credit problem. If people weren’t allowed to leave their homes and couldn’t go to the store or to work, then they couldn’t earn any money or spend any money. The blood of capitalism looked like it might actually freeze in the capillaries. Hence the massive transfusion by the Fed, which brought its own problems but did at least mean that economies and therefore markets could continue to operate.
This episode right now has, I think, some leverage problems. These aren’t easily observed from the surface; you can only see hints at the structure below. But when an ATS used by Interactive Brokers, Robinhood and others for overnight liquidity declares that it has not been able to settle trades that it said were settled? That’s a concern; probably a liquidity concern; and where you see liquidity concerns it’s usually because leverage is involved. In addition, that multiple major retail brokers prevented users from logging in yesterday? Also a concern. The VIX’s recent peaks plus stories of margin calls in crypto? Also a concern. All of this looks like it might, might, be a growing problem of too many people running for the same door at the same time.
My own response to the situation has been to reduce exposure. I have cut back my risk asset exposure in favor of cash, for now; my motivation is to protect the gains made in 2023-4’s bull market (we’re still in a bull market by the way). If this proves nothing more than a flash crash, there’s plenty of time to wind risk back on. If it’s something more serious then having a substantial cash allocation is usually one of the better positions to be in - ask Mr Buffett who typically is the last source of liquidity standing when all other pools have dried up, which is how you get very sweet deals when investing in America’s finest companies at the lows of a bear market.
Above all this is a time to manage your own risk. When the dust settles, whether the market moons or swoons next, nothing could be worse than saying “well, [fill in the blank] said X and [fill in another blank with a different name] said not-X, so what could I do?”. Sitting in a corner hoping that X or Y happens isn’t risk management. Being ready to deal with whatever the market may throw at you in half an hour is risk management.
The spoils from the market have been wonderful for nearly two years now; consider protecting those and taking many deep breaths before picking a side and plunging back in.
Cestrian Capital Research, Inc - 6 August 2024