In late January, Deutsche Bank suggested that going forward, investors in traditional assets are going to have start paying more attention to Bitcoin.
Their rationale was simple: cryptocurrencies had replaced short vol. as “the new frontier in risk-taking.”
Exactly a week ago, everyone was forced to acknowledge what a lot folks on Wall Street and a handful of fund managers had been saying for the better part of two years: the tail was wagging the dog. Between the proliferation of the short vol. trade (which, in its retail form, was embodied by XIV and SVXY) had conspired with what Marko Kolanovic has dubbed “quantitative exuberance” to create the following scenario (via Deutsche Bank):
Implied volatility is an index calculated from the price of a derivative product (options) of an underlying marketable security. However, we now have a “tail wagging the dog” situation where the price of the derivative product is feeding back into the price of the underling marketable security. Investors required to seek out high returns, even in the current “triple-low environment,” are under pressure to manage assets near their fund’s value-at-risk (VaR) upper limit (CTA, macro funds and volatility-targeting funds such as variable annuity funds and risk parity funds). This means that, structurally, they will increase their holdings of stocks and other risk assets when volatility declines, but reflexively dump risk assets when volatility rises.
Although the note that excerpt is from doesn’t exactly “stick the landing” in terms of a seamless transition to the purported Bitcoin-traditional asset nexus, the bank made an admirable effort. To wit:
Cryptocurrencies are closely watched by retail investors, affecting their risk preferences for stocks and other risk assets. Although institutional investors recognize that stocks and other asset valuations may have entered bubble territory (US equities’ average P/E is around 20x), they cannot help but continue their risk-taking. Now, a growing number of institutional investors are watching cryptocurrencies as the frontier of risk-taking to evaluate the sustainability of asset prices. The result is that institutional investors, who are supposed to value assets using their sophisticated financial literacy, analysis, and information-gathering strengths, are actually seeking feedback about the market from cryptocurrency prices (which are mainly formed by retail investors). We believe the correlation between Bitcoin and VIX can increase as more institutional investors begin trading Bitcoin futures.
Again, some folks said that was a non sequitur and it kinda is, but then again, it’s not entirely far-fetched and on Monday, Morgan Stanley is out with a new piece that draws a similar parallel between peak risk-taking behavior in traditional assets and peak Bitcoin.
Morgan begins by stating the obvious, which is that equities had finally had enough of rising rates which, as we’ve said over and over, will only be seen by stocks as a positive development to the extent rate rise is viewed as a barometer of the robustness of the global economic recovery. The second that perception changes is the second stocks start selling off with bonds. Here’s Morgan:
Two weeks ago,after the best start to a new year since 1987, US equity markets suddenly seized up and had their worst week in 2years. We also noticed this was all due to multiple compression as S&P 500 forward earnings actually rose 1% during that week leaving P/Es down over 5%. So what happened? To briefly recap, we think interest rates and inflation expectations finally reached a level that provided a restraint on equity multiples. Until two weeks ago, P/Es had been somewhat positively correlated to interest rates. But reflation is only good to a point. Did we reach the point where reflation is now restrictive to valuations? Could P/Es become negatively corrected to rates? We think it’s entirely possible and believe that at a minimum higher rates will no longer be a supportive factor for valuations.
Ok, well when they went back and looked at when multiples actually peaked, it was on December 18th, the day before the Senate passed Trump’s tax bill. Have a look:
Of course the market didn’t peak that day largely because earnings estimates were revised sharply higher giving everyone and their brother a fundamentals-based rationale for piling in during the first month of the year.
Anyway, here’s the punchline:
We think the peak for multiples/trough for ERP is in for this cycle and we saw it on the day the tax bill passed the Senate. Fair value on the equity risk premium today is around 300 bps and the further we go in the year the more we would expect the risk premium to widen off that level, leading to lower equity market valuations. Our year-end target multiple is 17x forward earnings, but if rates retrace some recent gains and market participants look to buy the dip aggressively, we could see some overshoot of this multiple in the near term, allowing the S&P 500 to reach our bull case of 3000 before forward EPS estimates peak later this year.
So watch bonds.
And the dip buyers.
Oh, and maybe Bitcoin, too.