Timing the Consensus Fade

By Kevin Muir

I was rummaging through the Commitment of Traders (COT) data recently and was struck by the number of futures contracts with record speculative positions.

Take a gander at the Euro currency net speculative position.

And how about the five-year US treasury future?

Too many asset classes feel both stretched and crowded. But it’s easy to see why.

The Euro has been consistently climbing the wall of worry and refuses to dip in any meaningful way.

And American fixed income? It’s been a trend followers dream.

For traders who like to fade moves, this has been an extremely difficult market to trade. The rubber band is stretched, but keeps getting pulled back farther and farther.

There is little doubt in my mind that many trades are due for violent snap-backs. But how do you know when to take the other side?

Well, I was recently talking with my favourite millennial hedge fund manager, Sam Gruen from Lightfield Capital, and we were lamenting about how difficult it was to time the turn. Sam then mentioned one of his indicators that he likes to watch. He explained how he creates a portfolio of “consensus” trades, and then proceeds to weigh them based on volatility. Finally, he tracks this portfolio, and when it moves more than one standard deviation, he uses that a guidepost that the chances of the larger traders unwinding their position has increased. This theory is based on the fact that many of these large funds use volatility as a stop, and when the “consensus” portfolio has an outsized move, they will pull the trigger and ring the register.

I told Sam that this was a brilliant, unique way of potentially timing the market, and encouraged him to write it up. In his usual modest way, Sam explained that it wasn’t scientific enough. Not scientific enough? Considering that too many traders are looking for Hindenburg Omens or double-camel-vomit patterns, I told him that I begged to differ. I petitioned that this was the perfect MacroTourist post and asked if I could write it up. I figured a few charts, a funny picture at the top, and Bob’s your uncle – we got ourselves a classic MT article.

Sam graciously agreed and even went as far to create the MacroTourist “consensus” portfolio. I differed a little from his perception of what were the crowded trades (must be the UK versus North America thing), but we finally settled on the following trades:

  • long Euro currency
  • long USDJPY (short yen)
  • short TY (US 10-year treasury futures)
  • short FV (US 5-year treasury futures)
  • long Nasdaq

You might disagree with the ones I picked. Crude oil has a big speculative long position, so maybe it should have been added, but I find many macro pundits awfully bearish on crude, so I can’t figure out who is actually long. And maybe I should have had 3-mth Eurodollar futures in there, but due to their low volatility, the notional would have dominated the portfolio.

Regardless, here is the portfolio Sam created for us.

It was created in MacroBond because this sort of calculation is not easily done in Bloomberg (if there are any Bloomberg experts who know how to easily accomplish this, please message me. I could pull it all into excel and make it by hand, but maybe I am missing a Bloomberg function that creates a volatility-adjusted rolling portfolio).

The top panel represents the performance of the index. Since July of 2016, it has been steadily rising. The second panel shows the volatility adjusted weights of the various asset classes. And finally, the third panel is what we need to keep our eyes on. This represents the volatility of the portfolio, with one standard deviation highlighted.

The theory being that if this portfolio starts hopping around and breaks out from the nice tidy volatility constrained channel, the position unwinding will come quick and ferocious.

And I would even argue that the longer that we stay within this range, the greater the positions become, and ultimately the more violent the reaction. What did Minsky say about stability breeding instability again?

Of course, Sam is correct that this is far from scientific. There is no proof that one standard deviation is the magic trigger. Yet understanding what is driving market participants and quantifying measures to monitor is the first step. And there can be little push-back that low volatility moves in the direction of the trend only encourage larger and larger speculative positions. Increases in volatility would be the shot across the bow that traders would be foolish to ignore. Sam’s insight that this should be studied as a portfolio of consensus trades is something that previously elluded me.

Although I am by no means advocating taking positions based on this indicator, I think it’s way more useful than much of the other stuff floating around the financial blogosphere.

So, for that, I would like to say – “thanks Sam!”

Thank you for reading,
Kevin Muir
the MacroTourist

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