The stock market saw an unbelievably strong run in August, erasing its pandemic losses and accelerating higher even as the economic and political situation remained highly uncertain. Notable positive developments in pandemic containment and economic growth warranted some investor optimism; however a dizzying spread of concerns and a crippled economy begs the question of how the market — supposedly a reflection of the real economy — could so breathlessly ascend amidst the continuing pandemic. The divergence between the market and economy was on display at the end of the month as markets claimed a full recovery while millions continue to struggle.
The month began with investors expecting another economic stimulus bill from Congress; but negotiations became deadlocked and no bill has materialized even midway through September. Amidst the impasse, President Trump declared a payroll tax holiday and additional unemployment benefits, but it is unclear if these actions will ultimately be beneficial to the economy. At the same time, tensions with China continued to flare as Trump banned popular Chinese social apps TikTok and WeChat.
The second half of the month saw more positive developments as COVID-19 cases declined nationwide and Moderna reported promising vaccine results in a small scale trial. The Federal Reserve cautioned that the pandemic would continue to weigh heavily on the economy, but threw investors a bone as they announced a new policy of “average inflation targeting” to maintain low rates even if inflation picks up. Low rates are generally a net benefit for stocks.
The news cycle seemed to have little effect on the market, which pounded higher out of the gate as the S&P 500 rushed towards its all time high. It encountered only minor turbulence before eclipsing its pre-pandemic peak, consigning the 2020 bear market the title of the shortest in U.S. history at only 33 days. Even after surpassing this threshold, the rally actually accelerated in the latter half of the month, blowing through its third century mark at 3500 by the end of the month. Analysts struggled to offer explanations for the red hot market in the absence of any economic or political basis; all that could be said for sure was the market was being very irrational.
As it turned out, massive volumes of options trading to the tune of billions of dollars fueled much of the market melt-up. Rampant speculation in the options market meant that counterparties such as brokers were forced to buy into stocks and indices as a hedge, driving stock prices higher and inviting even more option speculation in a positive feedback loop. More recently, it was revealed that Japanese conglomerate SoftBank was one of the biggest of these option speculators, funneling $4 billion USD into options on technology stocks as the lead driver of the option frenzy.
The scale of this manipulation seems to be further evidence that much of the rally is artificial, driven by fiscal policy and speculation, and dislocating the market from the real economy. The story of a V-shaped recovery is looking more and more to be K-shaped; with the investor class bouncing back with the stock market, while many others continue to struggle. In this scenario, the market recovery may ultimately prove to be fragile without a strong economic foundation, though there is no telling when that fragility may be tested.
Market conditions challenged our trading strategy in August as distortions in the option market inflated both stock prices and volatility, a known weakness to our strategy. Nevertheless, our experience using our strategy through a variety of markets allowed us to make steady performance headway through most of August. While we stated in July that we would be stepping back from our short trades, our analysis indicated it was a worthwhile risk, and we took a short position against the market towards the end of the month. Ultimately, the market continued accelerating through the end of the month, hitting our short trade hard and putting our portfolio at a loss for the month.
In August, we viewed the continuing market runup as unsustainable, especially after four straight months of significant gains during a pandemic. The S&P 500 had dashed through the 3300 and 3400 century marks which our analysis identified as areas the index was likely to revisit. This view was reinforced in the later stages of the month as the accelerating market displayed strong indicators of a blow off top. Most significant was a positive correlation between the VIX volatility index and the S&P 500, which indicates significant market distortions and is especially unusual when the market is making new all time highs, and a strong signal of a turnaround. While we normally try not to make directional intraday predictions to the market and just trade to our statistical advantage, the market was so stretched to the upside, we made the decision to trade short positions.
These trades proved to be ill-timed as the market continued to accelerate through the end of the month, and continued through our stop loss thresholds which forced us to close our trades. In the end, we saw our analysis of market conditions proven correct just a week later in September. Unfortunately, missing the timing is the same as being wrong when trying to make these kinds of predictive trades.
One of the main strengths of our main market-neutral strategy is the ability to perform without needing to time the market. Throughout August and the preceding months, our main trading strategy has been consistently successful in generating a positive performance despite volatile and changing conditions. Our losses the last couple months have been a result of us trying to time the market, and we would not have taken as much loss if we had simply followed our core trading strategy built around maintaining a statistical advantage. The losses we have suffered show the danger of attempting to trade a market narrative as opposed to our time-tested strategy.
Following the latest setback in our attempt to short the market, we put that tactic to rest at the start of September. Ironically, the very next day the market dropped significantly and our shorts would have been profitable. The lesson to take from this is that the market can always outlast us if we attempt to time trades. Instead, we should remain disciplined in trading our tried and true core strategy to generate consistent gain with its statistical edge. We must thank our clients for their continuing support as we face the challenges of the pandemic market and we hope to be able to make headway into recovering our losses by the end of the year.
*Incentive fee is calculated at twenty percent based on the difference of the high watermark and ending account balance for the Incentive Allocation period