Moontower #62

Friends,

Last week I mentioned how the “great pause” has led many to re-prioritize. More sunsets, less commuting. Probably wishful thinking. As things open up you will slip back into old patterns.

Consider Zack Kanter’s story about “the mechanic” capturing the essence of returning from vacation (emphasis mine):

My moments near the ocean feel like they will stretch on forever; in that instant, I cannot imagine feeling any other way. And I find that it is this way with all epiphanies – coming to some realization during a long talk with a friend, reading a particularly insightful book, marveling at the clarity of mind brought by a just-organized workspace. Yet the moments are always fleeting; we quickly return to our pre-enlightened state within minutes, or hours, or days. (Link)

Well, this is no time to be defeatist. We are going to need all the positivity we can muster. If you had a moment of clarity in the quiet, it was a privilege. The feelings of discovery or rediscovery are fleeting. The way to give your realizations permanence is to change their forms.

In mythology, the spirit sheds the body to find immortality. Here you must do the opposite. Maintaining the peace of clarity means transforming it from a feeling to physical actions. It’s not your mind that perpetuates the lessons from this “great pause”. It’s your habits. Be deliberate about how you will preserve what you found. Establish a new muscle memory. Turn the spirit into flesh.

How do you do this? Kanter has an answer:

And so I try to think in terms of process – that is, a specific action repeated on a regular basis, an improvement that stands the test of time. Try reframing one of your projects as a process: get in shape becomes go to yoga every day, declutter becomes put away one thing every time you enter the room, read more books becomes read for 15 minutes each morning. The truth is that all of your thoughts, wishes, and goals amount to nothing if they do not make the leap into your daily life.

The distractions are roaring back. If you go back to all of your old ways as the world re-opens make sure it was your active choice. These chances are rare.

After reading that “mechanic” post by Zack Kanter I read most of his blog.

Some of my favorites:

• Why Your Kid Hates School (Link)
• 10 Killer Negotiating Tactics [or, how I got $125,000 for nothing] (Link)
• 8 Simple Philosophies That Changed My Life (Link). #1, #2, and #5 are in my top 5 as well. #6 is very wise and I think the most underappreciated.
• 5 Steps To Creating A Product (Link). This is part of his “How I Make Money” series and this has really interesting business info in it.
• What I’ve Learned About Love (Link). This short post has a beautiful reduction: “I have since thrown away my list and replaced it with a simple philosophy. Find someone who you feel lucky to be with, and who feels lucky to be with you. Someone who you admire, someone who you want to become more like.”

It’s a dope blog. Happy yakshaving.

The Money Angle

My “No Easy Trades” Principle

A recurring theme here is the wisdom of markets. If you find yourself constantly disagreeing with prices visible to anyone with a smartphone you probably get invited to lots of poker games. This doesn’t mean markets are always right. It just means nobody can claim there is easy money in slanging investments around. It means your guess is not consistently better than the market’s. I highlight that distinction because it seems to be lost on efficient market detractors.

So my definition of markets being smart is not academic. It’s actually a survival heuristic — there are no easy trades. Today I will discuss 3 things.

1. What this heuristic looks like in the options market
2. The puzzle I stumbled into when applying this logic to stocks.
3. How the puzzle got cleared up.

Before I mosey into this we need to agree on a stylized fact.

Investment returns are driven by:

1. Actual earnings (returned to shareholders or re-invested)
2. Expectations (risk discounted of course)

So a stock’s return is driven by actual earnings (I call that the “realized”) and changes in the multiple (the forward-looking growth prospects is the “implied”). Same with real estate. If the cap rate is zero in one location and 10% in another it’s usually investors factoring in different growth rates. The actual rent is the “realized”.

As time passes, the market will pay attention to the fundamentals on the ground to revise the growth rates. Is this investment cash-flowing more or less than expected? So the “realized” earnings interact with the expected or “implied future earnings”.

Option Returns Are No Different

First, some reminders about options:

• Volatility is the standard deviation of a stock’s return. The amount of volatility that transpires until an option expires is a large driver of an option’s value.
• Nobody knows how much volatility a stock will experience during an option’s holding period.
• We know the other inputs into an option price. Since the other inputs are known, we say the price of an option implies a volatility.

For somebody managing a hedged options book, the p/l is driven by:

1. The realized volatility of the underlying

If the market bounces around 2% a day and you purchased the option implying 1% per day you will “capture” p/l in excess of the option’s time decay. (The p/l due to “gamma” exceeds the losses due to “theta”)

2. The implied volatility baked into the option

If the market suddenly believes the future will be more volatile, it will bid up option prices. This will lead to profits for someone who owns options. (The sensitivity of the option’s price to the market’s vote on volatility is known as “vega”)

Option Markets Are Smart

Without getting into the nature of realized and implied volatility it’s sufficient to say that they are mean-reverting. If a stock becomes more volatile, say moving 2% per when a longer history pegs it as a 1%-per-day type stock the options prices will increase to price the extra volatility. But as the realized day-to-day volatility reaches extreme levels, say 5% per day, something we may have seen in March, the option implied volatility will likely not rise by as much (I’m hand-waving term structure and more, it’s not necessary to the point). Why does the implied volatility not keep up?

Expectations. The market understands the shock is temporary. So there is no easy trade. People that want to sell or short expensive options will be disappointed to find that they will experience negative gamma p/l during the holding period because the realized volatility will exceed the implied volatility they had shorted.

And option longs who may be enjoying the positive gamma p/l (or “carry”) know that they have bought a high implied volatility that is eventually going to recede.

When option volatilities get very low the inverse dynamic occurs. There are period when the SP500 will realize less than 30 bps a day but the market never sells you options at such a low implied volatility.

It’s simple. The market will not let you have a position that simultaneously:

1. Carries well
2. And has a tailwind in the direction of the mean-reversion

Classic dilemma. You enjoy one while fighting the other. Market implied parameters reflect expectations. But expectations do not vary as widely as what actually happens because volatility is a mean-reverting quantity. Net result: no easy trades.

The Puzzle: Is The Stock Market Smart?

I presume the stock market is smart and must follow a similar principle of “no easy trades”. By analogy, I mapped implied volatility to P/E and realized volatility to actual earnings. So if profits (earnings) were high, I’d expect forward P/E ratios to discount the elevated earnings. Otherwise, it would seem like an easy trade to take the other side of a market that extrapolated unusually high earnings into the future. Just because LeBron drops 50 points one night does mean the “point futures” market is “49 bid” for the next game.

Now earning themselves are not mean-reverting. I wasn’t quite naive enough to apply my cargo-cult thinking to that metric. Enter fund manager John Hussman. He argued that profit-margins, which have been extremely high, are both mean-reverting AND being extrapolated into the future via fat multiples.

This was to be the rare set-up of an easy trade — a bear case with a double tailwind. Luckily I didn’t trade in my PA based on this. For all the $20 bills on the ground I miss out on, my disbelief in their existence has also saved me from being short stocks for the past 5 years.

So what’s the deal with the stock market? Can it possibly be extrapolating mean-reverting metrics with straight lines?

Carry On, Nothing To See Here

Well, it turns out there is no puzzle. Profit margins aren’t a metric that matters. It’s return-on-equity that matters. Get all the details from @jesse_livermore in his paper Profit Margins Don’t Matter (Link with my highlights). It’s several years old but the thinking that permeates through this paper is better than 99% of finance stuff you might read today. And if you are weak on accounting like I am you’ll want to bookmark this one.

Extra observations on the options vs stocks analogy:

• When an option has lots of time until expiration the implied expectations dominate its price. Conversely, as an option approaches expiration, the realized volatility will dominate. This manifests as the option’s vega decreasing while its theta and gamma increase.
• Unlike options which have fixed expirations, real estate and stocks are more like perpetuities making them highly sensitive to expectations.

Moontower Money Wiki (Link)

Latest updates:

• Risk Is Unavoidable, Let’s Get To The Good News (Link)
• TANSTAFL (Link)

Last Call

• Jon sends me an article like every 5 years. This one on skateboarding in NYC these days is a visual gem. Super cool. (Link)
• In a follow up to the WFH discussion here’s @can on how remote work may commoditize software developers. (Link)
• You have probably watched the Miracle Sudoku already but if not I promise it’s 25 minutes wonderfully spent. I promise. This guy’s joy is infectious. Watch with the family. (Link)
• A Shopping Cart Theory of human decency? (Link)
• Want to get your kids into coding this summer? Stefan sent me this great flowchart which can help you decide how to start. (Link)

From my actual life