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Meta Strategy Derivatives Portfolio – Probability Map Update

This table maps my current data-driven estimate of the probabilities for future returns of the S&P 500 over the short term (1 – 8 weeks), medium term (3 – 6 months) and long term (6 – 18 months). It is updated each Monday and whenever probability estimates change significantly. The key insights, price targets and model portfolios are all listed below the probability map.

For background information please read this article.
A quick guide on how to read this table and how to translate probabilities into a concrete portfolio exposure can be found here.

Significant changes since the last update

New Playbook Confirmed
The Meta Strategy signaled a regime switch to a new Bull Market environment one week ago and this is now confirmed by one week of stable price action and falling volatility.

A breakout to a new intermediate high (close above 3235) would strengthen my long conviction , but I would prefer an entry with better reward : risk as the all-time-high at 3400 is a significant hurdle and the danger for a sudden correction is still high – the S&P 500 is still caught in a range and may quickly reverse toward 3000.
My long-term portfolio will re-enter stocks (50%) should the golden cross signal be confirmed throughout July.

We are back to basic bull market assumptions (until we see a new regime change) and I will now re-activate suitable strategies and trading setups – but only at favorable entry points. Please check back on the target and trade setup tables as I will update them during the week as indicated.

• New breadth and fundamental data is supportive of the regime change thesis, but as long as volatility stays above VIX 20 choppy and fast corrections are likely to happen without warning. The bear case is losing a lot of its punch, because long-term forces have turned bullish according to our systematic strategy. Intuitively this is hard to accept considering the economic environment, but the likelihood is high that the market is telling us something significant and there certainly is a huge wall of worry for a new bull market to climb.
• While speculative excess is still high its quality changes with the new market environment and it will take considerable more evidence for me to go against exuberant sentiment. The focus will be on participation with tightly controlled risk as animal spirits are taking over a larger section of the market.
• A new section on asymmetric bets (scroll down to portfolio) broadens the universe to show additional ideas. I try to identify ways to participate in the current speculative environment while safeguarding against a sudden turn-around. Current ideas near good entry levels: Silver & China long.
• Looking for a summer read? The new, free Meta Strategy eBook is out now and details the basic philosophy that grounds my work.

July 20th Probability Assessment over the next 1-8 weeks 

Neutral / Long 60% : 40% (probability of positive : negative returns)
Conviction: Low
All index levels and probabilities are for the S&P 500 (including overnight futures) unless stated otherwise.

Probability ≠ Certainty: everything I state here are my personal ideas and best guesses, that I use to make my own investment decisions (I may hold positions discussed here). It is not investment advice. Everyone is responsible for their own investment decisions and potential losses.

Key Insights

(only change gradually and at major inflection points)

Current Market Environment (defined by the Meta Strategy Indicators): Volatile Bull Market Regime

• Systematic Long-Term Meta Strategy Portfolio: golden cross signaled return to Bull Market Regime on July 10th; volatility has normalized at a high level and is now accelerating its downward trajectory. This causes a significant bullish shift of the baseline probability impacting the estimates over all time frames.
• We are back in a „make money regime“, my preferred trading environment, until we see the next new regime change. A fake signal that reverts quickly has a 15% chance historically and I will ramp up exposure carefully as elevated volatility often results in choppy price action for a period of time.
• Basic Premise: Market Environments tend to stick around – adjusting strategies to the current regime and trading with the trend has the best chances for success over the long term.
• Big Picture: two major scenarios. Historical cases are skewed towards quick recovery by 10 : 5 – the Meta Strategy market regime change now makes the Bull Case my main playbook.
  • 1) Bear Case: The coronavirus shock becomes part of the top of a long bull market and this crash cascades into a longer economic downturn & severe bear market.
  • 2) Bull Case: The coronavirus impact is strong, but temporary. Enormous stimulus acts like rocket fuel to propel economic growth to bounce back quickly.

Current Influential Market Drivers

(details change frequently as new information is included continually)

• Several breadth indicators are turning positive on the broad market: A new high for the S&P A/D line and the percentage of S&P 500 Stocks > 200MA is back over 50%. Stock market breadth is improving as some overdue rotation from big tech into the broad market is visible = very important as lack of breadth and concentration in big tech was a major factor for concern, that is improving now.

• Nasdaq momentum, optimism extremes, Nasdaq vs. NYSE volume: Late-cycle speculation? Or early cycle thrust? Excess has often led to problems in the past, but just as often to a considerable period of outperformance before any setback occurred = short-term positive / long-term danger.  This leads to the big question: for how long to follow the wisdom (insanity) of the crowd and when to turn contrarian?

• Consolidation period: lack of pronounced direction has mellowed sentiment and there is now no clear cut negative influence anymore, but we are still range bound and waiting for a breakout = tendency for slightly reduced returns over the next 2 months.
• Equity fund flows negative: for 4 weeks = medium / long term positive.
• Quarter ends with 20%+ gain: strength begets strength – exceptionally great quarters are not a sign of the top for the S&P 500. After the end of rare 20%+ returns historically (since 1950) all following 6-month periods were positive – most by double digits.

• Instability after historic rally: danger signals still remain from multiple studies over the last weeks on parabolic tech momentum and very optimistic sentiment. Many indicators are easing off their extremes – a prolonged consolidation often has a similar effect dissipating sentiment extremes as a deeper pullback = danger, but no outright short bias anymore.
• Options traders still keep setting new speculative records: Put/Call ratio, speculation index, call volume = these data points are now the biggest cause for short-term concern.
• Contrary to that AAII investor survey shows low optimism= positive medium / long term sign
  • The high optimism indicated by the put/call ratios is negative for short-term returns, while the low optimism indicated by the AAII survey helped lead to above-average longer-term returns = most likely sentiment scenario is a short-term pullback and long-term gain.
• Hedgers vs Speculators: hedgers are more exposed to stocks than speculators by a wide margin = positive sign.
• VIX: VIX accelerates its downward trajectory & the VIX Futures Term Structure is back to clear contango. This is a very positive sign. A fall to levels below VIX 20 (current 25,68) would set the stage for a stable grind higher.

• 17.7. Gamma Exposure: @ 3210 = Long; Zero Gamma trigger = 3150; Call Wall/Top Gamma Strike = 3250; Put Wall 2900; Absolut Gamma 3200 (primer on gamma exposure). Reduces volatility; market drops are prone to snap back through hedger’s buying activity, but some exposure has come off the table through Friday expiration setting the stage for a longer directional move; trading setup “buy the gamma dip” active after new S&P high (3250 – see tables).
• Meta Strategy: golden cross signal on July 10th indicates Bull Market; Long-term portfolio: long Gold. Potential change back to Bear Market Regime has low probability, but switch back could happen quickly, if market drops soon & sharp: watch 275-dma.
• Studies Summary: Short term bearish/neutral, Medium term bullish, Long term bullish. 
  • Short term studies’ weakness is slowly dissipating in the current consolidation, medium term is now bullish and long term studies on trend and breadth are bullish.

Conclusion

We have recently changed to a bull market regime – the most profitable, „normal“ environment we are in about 75% of the time -, but there is still elevated volatility and short-term danger. I am currently identifying new good reward : risk setups and a great entry point would be after the first sharp pullback in the new regime.

For the moment high economic uncertainty battling unprecedented stimulus traps equity markets in a sideways move – it has a good chance to profit from increasing recent tailwinds and to break out to the upside during the week.

The most recent market studies show significant bullish tendencies supporting another potential leg up. But beware: we often see considerable volatility when coming out of a market turmoil while markets recalibrate to shifting outlooks in fundamentals and investor expectations.

Current most probable scenario

• Regime Change: the new bull market signal has a low probability of being false; higher medium- to long-term prices are likely.
• Short term consolidation in progress: the S&P 500 may break out to a new intermediate high with its next target at the all-time-high. A close below 3000 signifies a longer correction and a false regime change signal.
• Closest approximation may be the Spanish Flu era 1917/18.

Main Fundamental market drivers

• Central Banks vs Recession = extraordinarily strong stimulus & biggest, sharpest GDP decline in history: This is the irresistible force meeting the immovable object.
  • Key question: economic slowdown vs. fiscal stimulus – what will be stronger? Evidence points to round #1 going to the FED and shows up in an increasing number of strongly improving fundamental indicators.
• Several economic data points continue to bounce back strongly: economic data continues to surprise to the upside and the Citigroup Economic Surprises Index is skyrocketing; Industrial Production rebounded more than 5% from a multi-year low; Small business sales outlook and optimism rebound strongly = all of these provide a strong tailwind to equity markets specifically over the medium / long term. Historically this has raised base rate upside probabilities (which are already positive – see probability table) by 10% to 20%.

• FED liquidity is ticking up again: liquidity support for next leg higher is growing; Fed’s assets slowly start rising again after five straight weeks of declines (by $38bn).
• FED Put: no-limit QE now has investors convinced that there is a bottom to asset prices that will be defended at all cost.
• US election: is going to become an increasingly important factor. Extending Biden lead points to stock market weakness in July / August.
• The economy: U.S. economy snaps back faster than expected. But the perfect recovery, that is now priced in, is facing headwinds from a pandemic that is still raging uncontrolled.
• Stock Valuations: are high, capping prospects for a new, long bull market. Predictive quality of valuation levels for stock market returns over time frames below 5 years is low, however.
• Coronavirus: after a full stop the world economy is restarting – economic data deteriorated to Great Depression levels.
  • Areas of infection resurgence are accelerating significantly, worldwide cases and specifically infections in the US rise to new highs – this is largely ignored by the US national and many state governments. Second wave fear is increasing which could be a decisive factor in slowing down the nascent economic recovery. As of now the stock market is looking past these developments.
  • Current Corona data

Further Outlook

• Bull Market Environment: follow systematic Meta Strategy signal. If confirmed for some time, this is the best trading environment because the bullish medium/long term outlook is aligned with the stock markets basic upwards tendency for high conviction setups.
• Exogenous Shock Bear Market: short (avg 15 months) and shallow (avg 30% decline) historically and may have ended now in record time.
• Shortest bear market in history may morph into a long, recessionary bear market – pandemic may trigger overdue economic decline after the longest bull market in history. It’s becoming less likely, but the incredible market moves this year may be part of a long term top leading to a long & deep repricing of equities, if widespread economic weakness trumps unlimited stimulus. Caution and risk control is still important.

Target Areas for the Meta Strategy Derivatives Portfolio

Long Targets	target reached	comment	target probability	derivatives exposure change*
3235		intermediate high, breakout (close above)		add long on breakout
3400		all time high

*size of planned exposure changes = max. position / number of targets (details in planned portfolio adjustments)

Short Targets	target reached	comment	target probability	derivatives exposure change*
3125		last minor low
3000		long-term trend, significant double low	min. target
2800 – 2840		38% of rally; regime switch necessary	low

*size of planned exposure changes = position / number of targets (details below)

Current Trade Setups

Check back for updated tables during the week when indicated key levels are reached.

Buy The Gamma Dip: (High probability short-term trade – rules see Worksheet)

Enter long S&P at any random 1-2 ATR (30-day average true range = average daily market move) dip in an uptrend. Trade setup is now active with long gamma exposure and a new S&P 500 intermediate high (Levels are updated with new highs).
Main driver: at long gamma exposure option market makers are forced to buy market dips to adjust hedges, often causing a quick snap back rally.

Preferred Instruments: ES/MES Sep. Futures or CFD

High S&P	Entry 1 (H-ATR+10)	Entry 2 (h-1,5xATR)	ATR (30)	Avrg Entry	Stop Loss	Profit Target 1	Profit Target 2	Risk
3285	3215	3185	60	3200	3120	3280	3400	1%-2% NAV

The Meta Strategy Derivatives Model Portfolio

Full disclosure: these are the current positions and instruments I am invested in with the capital dedicated to the Meta Strategy Derivatives Portfolio.
A balanced exposure to the current probability estimate is achieved by combining long-term ETF positions with derivatives that are held short-term.

Positions may change at any time – roughly according to the target tables above, but exact entry and exit points may vary. Instruments are not a recommendation as there are many equally valid ways to express current probabilities; e.g. ETFs, volatility products, CFDs, futures and many more. Also the decision of how to set maximum leverage and risk levels fits me personally and every trader has to be mindful of their own risk tolerance.

Investment Portfolio: the Meta Strategy Aggressive ETF Portfolio (with 80% of the capital dedicated to the Meta Strategy Derivatives Portfolio)

• Meta Strategy long term exposure: 50% Gold ETF according to the monthly Meta Strategy newsletter; re-entry S&P 500 ETF planned in August.
• The probability map indicates an investment in a long S&P 500 ETF – as the chance for a short term pullback is still high I’m waiting for a confirmation of the golden cross entry signal until the next monthly newsletter on August 5th to place the long-term trade.
  • planned portfolio adjustments: add long S&P 500 ETF, if regime change is confirmed throughout July.
  • maximum risk (approximate distance to exit): Gold ETF: 12% – 15%
  • positions: a hypothetical 100k portfolio would hold 40k in Cash and 40k in GLD
  • comment: my conviction in an immediate return to a lasting bull market is still low as the disconnect between fundamental weakness and technical strength is extreme. I will therefore scale in slowly and defensively into new long positions.

Trading Portfolio: derivatives sleeve (20% of capital – the size of this is the decisive factor for the maximum level of portfolio leverage)

• 100% Cash (or up to 20% in asymmetric ideas: if invested scale down related trades: eg. long China is correlated to long S&P)
  • recent trades: asymmetric ideas
  • planned portfolio adjustments: long after breakout (close above 3235); Instrument: ES/MES Sep. Futures (or CFD, 3x ETF, etc. – avoid options because of falling vol); Risk 1% – 2% NAV.
    This trade substitutes the indicated long-term ETF position that I am waiting to enter in August. It overlaps with the more flexible Gamma Dip trade setup and I will enter in a small pullback after a successful breakout according to the trade table above (updated with new highs).
  • Meanwhile I monitor trading setups to validate that the new market environment is generating profits:
    “buy the gamma dip” setup worked great last week (no position yet, because setup requirement „new intermediate high“ was not fulfilled);
    the next moderate VIX spike will be a good opportunity to scale back into short volatility strategies.
  • maximum risk: none (asymmetric ideas: individual trade risk)
  • positions: a hypothetical 100k portfolio would hold 20k in Cash; minus asymmetric trade ideas (Silver & China)
  • comment: We are finally back in a „make money regime“ (opposed to the previous „preserve capital” environment), but portfolio adjustment to and confirmation of the regime change will take some time.

Current Portfolio Leverage Level (approximately, stocks only): neutral/long (this can be adjusted by dedicating a different percentage of available capital to the trading portfolio which will influence maximum leverage levels strongly)

Trading Opportunities with highly asymmetric potential

I may or may not trade these opportunities. I will track them (identifying good entry & exit points each week) in this separate section to keep the model portfolio uncluttered – they can simply be added to the Trading Portfolio allocation keeping in mind individual maximum exposure limits.

Working thesis
We are in a speculative environment that is now supported by a bullish long-term market trend. Strong momentum often holds for considerable time before turning around violently. I try to identify setups where a strong momentum move is clearly visible, but still has potential to keep on running. We are playing with fire and face one of the hardest questions in investing: for how long to follow the wisdom (insanity) of the crowd and when to turn contrarian? Small position size and risk control is paramount.

How to trade it
Most of the ideas are aligned with an anticipated or beginning parabolic move that will either happen fairly soon or else fail. Despite high premia I prefer playing these trades with directional long-term (6 months+ to expiration) OTM options: they will leverage the move and keep risk constrained to the amount of premium paid – a small position can go a long way in a parabolic move.

• Long Silver (SLV or SIL): is starting to play catch up to the gold rally? Precious metals have significant fundamental drivers behind them; they historically performed strongly after economic troubles, during heightened inflation expectations and loose monetary policy. Silver is just turning up from a long term base – following gold which has broken out several months ago.
• Update: The $20 – $21 area is the next big hurdle ($18 – $19,5 in SLV) – a close above would be a breakout from a huge 5-year base.
• SLV Entry: $17-$18 or enter / add on breakout above $19,5; Instrument: Dec $19 Call; Position size: 2%; Risk 50% – 100% of premium (1%-2% NAV)

• Long China (ASHR): a market that currently leaves even the Nasdaq behind in the dust. Historically a similarly extreme momentum push has frequently led to a frenzied rally lasting several months. Government backing and rising retail interest are strong positive clues.
• Update: Retracement into massive breakout area under lower volume gives good reward : risk entry point, but price should advance again soon and not fall below ASHR $30 (4200 in the CSI 300 index)
• ASHR Entry: $31-33; Instrument: Jan $37 Call; Position size: 2%; Risk 50% – 100% of premium (1%-2% NAV)

Interesting things I read this week

• Thoughts on the battle between momentum and mean reversion by Macro Ops
• Thoughtful thread about the CBOE Equity Put/Call Ratio reaching an extreme low by Mike Shell via Twitter
• More on the influence of option generated forced order flow on the market by squeezemetrics.

Disclaimer

This report is a description of my own investment approach and ideas and I personally invest in the Meta Strategy Derivatives Portfolio. The content of this letter is for entertainment purposes only and not meant to be investment advice to others.

I am not an investment advisor and I do not provide individual investment advice. None of the ideas in this letter are meant to be construed as professional financial advice.

Your investment decisions are solely your own responsibility and I am not legally or financially responsible for any losses you may incur from reading or using the content on this letter.

© 2020 David Steets, all rights reserved – please be fair and do not distribute without my permission