No volatility in risky occasions | USAEMALL.com

Good morning. OpenAI, SoftBank and Oracle are unveiling a major AI infrastructure project, to be called “Stargate”, with a $100bn initial investment and another $400bn over the next four years. Big numbers, but remember the context. Capital expenditures at Alphabet, Amazon, Meta and Microsoft in the past 12 months totalled $200bn. In other words, a hundred billion dollars is table stakes in the AI infrastructure game. Email us: robert.armstrong@ft.com and aiden.reiter@ft.com. 

Where’s the (implied) volatility?

There is a new American president with an economic agenda that is long on radical ideas and short on specifics. We have just endured the first major inflationary incident in decades — and it may not be over yet. Stocks are at extremely high valuations and long-term bonds yields are in flux. Federal Reserve monetary policy rests on a razor’s edge. Uncertainty, in sum, appears to be everywhere. Why, then, are indices of implied — that is expected — stock and bond volatility so low?

The Vix index, the options-implied movement of the S&P 500, moved down yesterday, and at 15 it is below the threshold usually taken as a sign of market fear. The Move, the equivalent index for Treasury yields, is trading in its usual band. The implied volatility of investment-grade credit spreads is near a multiyear low, too.

These indices are based on the prices investors are paying for portfolio insurance, in the form of put and call options. Shouldn’t insurance be expensive right now? One explanation is that there is too much policy uncertainty. As a result, there is not much speculation in the options market, which suppresses volatility indices. From Russell Rhoads, head of research at EQDerivatives:

Most professional traders seem to be in a wait-and-see mode. Wait-and-see implies they are not putting new hedges and not speculating too much, as they don’t know what is coming around the bend . . . For the Vix to be active, you need a lot of activity in the index options.

The same logic applies to the Move. Traders still don’t know how to price Donald Trump’s unique mix of populist and conservative policy promises. The market, perhaps, is like a deer in the headlights.

Another possibility: there was a mechanical flow-through from good recent earnings and economic results to lower implied volatility. Fourth-quarter earnings results have been strong so far, causing a rally for those who have reported, but not for those who haven’t. Last week’s inflation print was not as dire as many predicted. According to Garrett DeSimone at OptionMetrics, those both “translate to lower market volatility”: diverging equity performace lowers correlation, in turn lowering the Vix, and the fall in inflation expectations pulls down bond yields, “which would be supportive of both a lower Vix and a lower Move”. 

That does not mean that there is no volatility in markets. Trump’s tariff threats have appeared, logically enough, in currency markets. Rates svengali Ed Al-Hussainy at Columbia Threadneedle notes that: 

Markets have focused on foreign exchange as the key adjustment mechanism in response to tariffs (higher tariffs = stronger dollar). The rest of the policy mix — immigration/taxes/regulation/etc — is too amorphous to price. This leaves a lot of room for last year’s positive economic/earnings growth story to continue driving risk higher.

At some point, policy proposals will turn into policies, for good or ill. Until then, the usual “fear gauges” might not tell you much.

(Reiter and Armstrong)

Unhedged 2024 stock picking results: bad

After hideously bad results in the FT 2023’s stock picking contest, we hoped to do better this year. We did worse. Not in terms of returns: in 2023 our high-risk short positions left us down 67 per cent. In 2024, we were down a mere 7 per cent. Here’s how our picks behaved: 

But these results were worse in the sense that the portfolio — with one exception — was a group of sensible long positions on biggish US companies. To be down in an up year with such a strategy is a proper embarrassment, whereas losing big on wild bets is sort of fun. 

Here’s how we introduced our picks last January:

We don’t have a ride-or-die bet about macroeconomic conditions, as we did last year. We are not going to bet that inflation or growth or rates are going to be higher or lower than expected. But we are going to gamble that the biggest trend in the market is going to reverse: that growth stocks generally, and specifically the Magnificent Seven tech stocks, are not going to lead the market.

Well, that was wrong. The market did not broaden. We should have bet on the Mag 7. Instead we did this: 

We are going to look for stocks that have reasonable valuations and solid secular (as opposed to cyclical) growth profiles.

That sounds sensible enough. What went wrong? Infuriatingly, of our four picks that fell, all but one of them, Dollar Tree, have delivered double-digit earnings growth over the past year. But at Everest, Cigna and General Dynamics, valuations (price/earnings, price/book) fell while earnings rose. This is, it goes without saying, very mean and unfair. Specifically, very mean and unfair things happened to these stocks:

• At the reinsurer Everest, the growth story remained more or less intact, with written premiums growing nicely and loss ratios fairly stable. But the growth slowed down in the third quarter, and the company has broadly hinted that it may have to increase reserves significantly; an announcement is expected soon. The stock started cheap and got cheaper. That being said, I still like the reinsurance business, and the stock.

• Cigna was having a good year until a bipartisan bill that would force insurers to separate their pharmacy management businesses (Cigna has a big one) began to circulate in Congress. The murder of a UnitedHealth executive didn’t help any of the health insurance stocks, either.

• General Dynamics and every other military contractor started to fall when it became clear that Trump — who promises to end US involvement in Ukraine and bring peace to the Middle East, and cut government spending to boot — would win the election. I still like the stock, though.

The real disaster of course, was Dollar Tree. Last year, I thought the discount retailer, which has been enormously profitable in the past but was whacked by inflation and a terrible acquisition, might be set to turn around. It had an activist investor and a new CEO. Things got worse, instead. The chain’s core customers, lower-income households, have continued to pull back on spending as the rest of the country prospers. The acquisition is proving hard to unwind. And dollar stores import much of their goods from China, so an increase in tariffs could hit them hard. 

The other three losers I can more or less write off to bad luck. But with Dollar Tree, I misunderstood the risk exposures of its business model, and misunderstood the structure of the US economic recovery. The China/tariffs issue did not occur to me but should have. I thought middle-class people, stung by the cost of living, would trade down to dollar stores. But they kept going to Walmart, while poorer households simply spent less — at the dollar stores, in particular.

Stockpicking is hard, and should be left to people who do it full-time. But the stock picking contest is great fun and never fails to be educational. We will talk about our picks for 2025 in the days to come. 

One good read

American oligarchy may sound scarier than it is.

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