It was never about Jay Powell. It was options.
As the market reeled Monday, the Talking Heads declaimed that Donald Trump was responsible: He was going to fire Jay Powell.
We said before the market faceplanted and recovered that it would likely fall Monday with new options trading. Well then. It’s not Jay Powell. The cause preceded the move, as it always does.
How did we know? Because options expired Thursday and Friday last week. Options are roughly 20% of market capitalization. Short volume remained above 50% of volume.
It’s a signal that demand for new options was below supply. Every day, every week, options lapse and renew. Those are speculative. No movement in the underlying asset class. But monthlies. Those are big. A LOT of market cap.
Why?
Because the behemoth of the stock market, Passive Investment, relies on them for tracking index futures.
We surmised stocks could drop.
All indexes benchmarking stocks – S&P 500, Dow Jones Industrials, Nasdaq 100, Nasdaq Composite, Russell 1000, Russell 2000, etc. – are futures contracts. They’re not stocks. They’re derivatives.
Passive Investment tracks a “benchmark.” The benchmark is determined by futures contracts predicated on the stocks in “the basket,” the thing creating the benchmark.
Seems circular? Well, it is. But it’s the way the market works. Best you understand it, investors and public companies.
Every month, banks and their customers gear up to buy and sell derivatives on stocks. Some sell volatility – a right to act on how stock prices move in the future. Some buy it – traffic in calls and puts to speculate on market-moves.
And some just need to approximate a market sample. If the stock market were 20 stocks, and ten rose and ten fell, and the movement of the combination was less than 2%, there would be little volatility.
But suppose five are up 2%, five are down 2%, and the other ten are a complete trainwreck in every direction. How do you “track the benchmark?”
You engage a bank like Goldman Sachs to iron out all the swings, for a fee. Monthly options. This is not a sideshow. It’s twice the size of stock-picking, which is 10% of volume.
On April 21, new options were stacked up in the store windows like donuts, jewelry, dresses, blazers. And customers weren’t buying. Prices plunged as purveyors put everything up for sale.
Yet we could know how much they would discount prices. About three percent, the five-day average volatility in S&P 500 stocks. Look back at Monday’s trading. Most broad measures hovered around 3% declines.
Meanwhile the banks and their customers who sold all that stuff were themselves “insured.” They had offloaded risk of losses to those willing to earn a fee on the bet.
So stocks would rapidly rebound. It’s math. I bought a leveraged long play on the S&P 500 Monday in the last hour of trading.
How about tariffs, recession, weak dollar, blah blah? Since WWII, the USA has pursued a foreign policy meant to benefit the world. We have had open markets, zero tariffs. We’ve had the highest standard of living. We pay for the defense of the western world.
Our politicians have believed it’s your responsibility, American taxpayers, to elevate everybody else’s standard of living.
We’ve permitted everyone else to make the things we buy and sell them to us, free of charge. The world has enriched itself on the American economy. Our jobs and manufacturing have shifted overseas, from tomatoes in Mexico to phones in China. We lifted the entire global barbell of prosperity ourselves.
And we racked up $36 trillion of debt doing it.
Switzerland would never do something that dumb. Switzerland isn’t awash in debt, deficits and products made in China. Switzerland almost always balances its budget.
As Apollo CEO Marc Rowan said, paraphrasing (WSJ subscription required), we’ve been the most open market in the world since WWII. What’s wrong with being 10th or 20th?
Back to stocks, why are they zooming? Bets are sorted out, indexes are squared (and about the time everybody stops talking about tariffs, stocks will tank again). Look at TSLA. We could see that bets were long before earnings. Bets are twice as large as rational investment.
Public companies, adapt to this market! We’ll help you. It’s a product market, not a story market.
And investors, forget buy-and-hold. The Nasdaq yesterday was less than 2% higher than it was in November 2021. The S&P 500 is up 10% since December 2021. Inflation has sharply outpaced public equities.
Own SPX when Demand is rising, like now, and don’t own it when Demand is falling. You have to be nimble. SPX Demand has risen from 1 to 7 in five days. Already one should be reducing exposure.
