"turds floating to the surface before the flush"

One of the first lessons I learned in trading is how the tip of the information spear is the futures market. ES moves before the SPX cash index (ie the ordinary shares). That’s because the futures market is both liquid and levered (margin requirements are 5-10% of notional value).

It was an early lesson because I was a clerk in the SPY ETF pit on the AMEX.

[“Clerk” is a ratty title for an assistant trader but as a Randall-maxi from NJ it suited me just fine.]

SPY ETF arbitrage was similar to index arbitrage. The futures have a basis or “cost of carry” differential vs owning the underlying basket of 500 stocks in their correct proportions. The index plus the basis comprises the index “fair value”. When bullish news leaks into the market the futures rocket above this value drawing the arbs to short the futures and buy the shares. The spread is called the “premium” (or “discount” if the futures are “trading under”). It’s a number you see during CNBC pre-market which gives an indication of where stocks will open.

The “futures leading the cash” is an instance of a wider principle that derivatives often lead. That again follows from the fact that they are levered and usually more liquid. We recently learned this is so true in India that options are practically the primary market! Even here in the US, you can argue that the HYG etf is where price discovery in high yield credit happens. ETFs like HYG and SPY are derivatives. Their fair value is derived from an underlying basket, but their price moves faster — so by looking at the ETF the logic is inverted — “if the ETF is trading for X then the basket is implied at Y”.

Another example of derivatives become the underlying

Options are insiders’ weapon of choice because of their leverage. It’s also why we give a lot of respect to single stock option orders — they can be information-rich. It’s also why the SEC pays (paid?) attention to option markets so closely. They know cheaters like ATM or OTM options.

I was thinking about this idea generally as “leverage + liquidity” lead.

So what lags?

Staying alliterative:

“Illiquid and indirect”

Illiquid: ordinary shares, cash bonds, real estate, PE (famously so as their selling point to some is “volatility laundering” since they aren’t MTM and can mask their gyrations)

Indirect: Investing in power generation as an oblique AI play, buying wheat vol instead of oil when Russia invades Ukraine, buying potatoes in the wake of the Chernobyl disaster.

2 of the more clever people I follow in trading, Scott and Lily, have hinted that the laggards “catching up” is something to watch as a contrary indicator.

Scott calls it the “turds floating to the surface before the flush”

the phenomenon where money keeps chasing assets further out on the risk curve which becomes a cause of momentum crashes

He cites the 2012 paper Momentum Has Its Moments.

From the abstract:

Compared with the market, value, or size factors, momentum has offered investors the highest Sharpe ratio. However, momentum has also had the worst crashes, making the strategy unappealing to investors who dislike negative skewness and kurtosis. We find that the risk of momentum is highly variable over time and predictable.

Lily (I can’t find the tweets) understands the psychology of turd buyers. I’m paraphrasing but it’s basically fomo investors who missed a large move and are now scrambling for the knockoff or discount version.

(Just me speculating but I’m guessing a lot of people overtrained on value thinking are highly prone to this mistake — it doesn’t strike me as the kind of error momentum-based investors make. They have their own issues.)

When the turds float up, does the risk/reward on near or medium time scales start to rollover? Seems like an interesting area of research. I would expect the turd buyers to be especially weak hands since their purchases were not rooted in conviction but fear (of missing out).

If turd rallies are coincident with falling IVs (typical stock up, vol down) then that presents as an opportunity for cheap bets on reversion that might get sloppy on the unwind. Just a thought.

If anyone launches the Mr. Hankey Flagship Fund, feel free to advertise in moontower.