When markets crash and prices readjust to a material level the masses begin to rationalize anything and everything. This week we heard a serious push by media and newspapers to not say "crash" and implore the use of "correction". The Fed launched so much crap on the fan that it spread far and nearly everyone's mental sensitivity to fact and fiction jumped out the window like the bankers back in 2013.
Luckily we didn't hear anything more about Vomiting Camel formations but there was certainly an ample amount of "it's priced in" blaring in the background. For those proclaiming technical levels on TV and rationalizing 400 to 5,000 P/E levels based on expected capabilities some 10-30 years out I wish you luck.
What happened recently that no one seems to be addressing is the explosion in OTC equity-linked derivatives. Recall in Q4 2014 when Zero Hedge highlighted content relating to the surge in WTI-linked structured paper. It was a disaster and look where we are now with oil, it's basically being blamed for the awesome life we thought we had $60 to this economy crushing, world ending level of $45 handles with 10% one-day moves.
Oil prices have nothing to do with supply/demand and everything to do with the contracts that are tied to the commodity incorporating interest rates, risk, insurance, and whatever else can be used to market these complex instruments to fearful participants.
If we have learned anything since Reg-NMS was implemented and HFT was able to run wild throughout our markets we've learned that derivatives now drive underlyings thanks to the ease of constituent snap-shots which help to calculate the NAV of the derivative instantly and arb the constituents. Now we have OTC equity linked derivatives that will be driving asset prices.
According to data from the Bank For International Settlements (the central bank of central banks) OTC equity-linked derivatives with maturity under 1 year have boomed well beyond the 1-5 year options and the 5 year plus option (higher than in 2007):
Swaps, for those unversed, involve two parties exchanging payment streams directly related to some notional amount for a specified period. The Swaps market isn't much better though; it has stunted growth since the 2008 financial meltdown. The Swaps market has seen Notional expansion amid a decline in the real value of the products as shown by the divergence between Notional amount and Gross Market Value amount:
Next is the Forward Contract value. This contract offers to pay or receive a set rate on a specific obligation for a set time period and begins at some future date. While the Swaps are seeing some longer (6 years currently) of sideways action the Forward Contracts are seeing some hot action to the upside:
The point here is that while TV and newspapers want us to think secondary common equities drive the Equity Indeces and that's the gauge of the broad market - they are all painfully wrong and late to this dramatic shift in how assets are priced. Equities and their demand by those watching TV or sitting on equity desks is not the end-all focus point on determining nation specific financial health (which many outlets do proxied through the Dow and S&P 500 every single day, hourly). The notional value of the forward contracts exploded in 2008 as firms exchanged the steady drip of payment streams offered by Swaps for the lump-sum payment offered by Forward Contracts. This is evident when comparing the YoY Change in Forward Contract Notional Amounts to the 6-month return on the S&P 500 Price Only Index and the FTSE 100 Index:
Total OTC Equity-Linked Derivatives:
Notional Forward Contracts (Billion of USD) Vs. S&P500 Price Only Index:
Notional Forward Contracts (Billion of USD) Vs. London's FTSE 100 Index (London is the derivatives wild west):
Looking at the 6-month change in the S&P 500 and FTSE 100 against the YoY change in Forward Contract Notional Amount shows a unique relationship. When the Forward Contracts Notional Amount YoY Change exceeds 30.00 percent both indeces returns explodes over the next year. Sadly, the Forward Contract data for June 2015 will not be released until around November 15, 2015. The BIS does note in their most recent report that “The gross market value of outstanding derivatives contracts – which provides a more meaningful measure of amounts at risk than notional amounts – rose sharply in the second half of 2014”. Ok, here’s that data:
Gross Forward Contracts Vs. S&P500 Price Only Index:
Gross Forward Contracts Vs. FTSE 100 Index:
The industry took a major hit in 2008 and has been trying to manage the mess ever since. The derivatives run the underlyings nowadays, this is why it's not priced in, it's never priced in. The information contained in the OTC derivatives market is hidden from us all until 6-12 months later when the BIS lets the world know just what the hell is happening there. But I guess this isn't easy enough to cram into a 5 minute segment so let's just ask random people if "it's priced in" and we'll recommend Alibaba at $115 saying it's totally going $150 before the equity collapses to a $70 handle right before our commercial for trading the options runs for the 15th time before the lunch. It's not priced in, it never was priced in. As reminder to what happens when you listen to people who own options clearing houses on TV pumping a new IPO's here's Jamie Lissette, operator of Hammerstone Chat, reminding his followers the dangers of TV advice:
remember this next time you turn up the volume on financial media...$BABA pic.twitter.com/36lQQEYooR
— Jamie Lissette (@jamielissette) May 5, 2015