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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:

• The stock market continues to work its way towards a regime change straight back to a bull market.
• At the same time growing evidence for speculative excess and euphoria is signaling danger on the long side.
• Fundamental economic data is far below 2019 levels and equities look to be disconnected from economic reality and brewing danger in society.
• This points to long term positive (but fraught with danger) & short term negative stock prices as the most likely outcome.

Caution warranted
I am very cautious, with low conviction and only hold a small derivatives position to preserve capital for a clearer environment. It is better to wait for the fat pitch as the market is currently prone to violate the most probable historical patterns and repeatedly takes the less likely path.

JUNE 8TH PROBABILITY ASSESSMENT OVER THE NEXT 1-8 WEEKS: 

Short 40% : 60% (probability of positive : negative returns)
Conviction: Low
All index levels are 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: Bear Market, but major indications for imminent regime change appear.

• 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.
• Uncertainty: High Volatility Regimes are hard to trade; the focus is on preserving capital for the next bull market; to stop trading altogether would be a sensible decision for the moment.
• Big Picture: two major scenarios – historical cases are skewed towards recovery by 10 : 5 (= following the basic economic growth trajectory) – especially after exogenous shocks
  • 1) Bear Case: The coronavirus shock speeds up the usually drawn out 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.
• Decisive Area: according to the Meta Strategy the market environment changes to a bull market regime when the 60-day MA (simple moving average) crosses above the 275-day MA (golden cross). The VIX futures term structure has already returned to clear contango (first 3 futures months display continually higher prices).
  • We are hovering right at the edge of changing straight back to a bull market regime in the recent epic rally. Such a V-shaped recovery with no deep pullbacks is a historic rarity and only happened in a similar fashion in 11/1929, 10/2001 (after 9/11) and after the last deep correction in 01/2019. Such relentless momentum was usually unsustainable and often led to a continuation of the bear market or a couple of choppy months before the rally resumed.

Current Thoughts

(details change frequently as new information is included continually)

• Trend and breadth measures are turning positive: these are the first signs of a possible regime change. Studies that were swinging around last week to signal increasingly positive medium to long term conditions are getting even stronger.
• Overextended rally: an opposite indication comes from the speed of the recovery. The Nasdaq rallied back to all-time highs in a little more than two months – when many stocks jumped this quickly, the market usually pulled back over the next weeks.
• Speculative excess: exposure to mega-cap growth stocks at 10-year high with extreme trading activity incl. options = negative indication
• Extremes can become even more so and the market is still rising fast (the picture looked similar last week at lower levels)
• VIX Term Structure: reversion to clear contango curve (first 3 futures months display continually higher prices) for the first time since March is a second major positive sign.

• 5.6. Gamma Exposure: @ 3190 = long; Zero Gamma = 3040; Volatility trigger = 3045; Call Wall/Top Gamma Strike = 3150; Put Wall 2800; Absolut Gamma 3000 (primer on gamma exposure) = volatility is dampened as hedgers buy dips and sell rallies, watch for changes at big June 19th OPEX.
• Meta Strategy: reached technical Stop Loss Level in March and indicates RED = Bear Market; long-term portfolio is short S&P500 ETF & gold. Potential change back to Bull Market Regime is very close.
• Studies: Short term bearish, Medium term shifting more bullish, Long term bullish. 
  • Most short term studies indicate weakness (the recent rally is overstretched and speculative euphoria is excessive), but now an increasing number of new medium and long term studies on trend and breadth are turning bullish.
  • Fundamentals are extremely bad and signal prolonged bear market, but signal may be late due to fast shock, recovery & stimulus. Some signs of improvement from low levels now (e.g. financial conditions, unemployment rate). Valuations are very high.
• Sentiment (contrarian indicator): typical bear market cycle ends with capitulation and despair, but we only saw initial panic in March and are now back to speculative excess.
  • Option trading: small traders take extreme bets on a rally with 50% of their total volume on buying speculative call options – an extreme that was last seen in the beginning of 2000 when the tech bubble popped.
  • Put/call ratio: six year low at 0,4 indicates pure euphoria = bearish even in the best of times

• Market Barometer: (Alvarez technical model combination): turned to neutral from bearish this week

Conclusion

Conflicting signals from price and breadth recovery (medium/long term positive) and the surge in speculative activity (short term negative) leads to reduced conviction and lower portfolio exposure on the short side. Switch to long exposure may happen soon, if market regime changes.

CURRENT MOST PROBABLE SCENARIO

• The picture is unclear, volatile and noisy at the moment: (historic precedents do not fit well) = low conviction
• Undecided: rising chance for a positive regime change and falling likelihood of the resumption of the bear market. 
• Short term pullback: in both cases a short term pullback still has a high probability

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. 
• Rising tensions: trade war, demonstrations, reduced social distancing – storm clouds are brewing, but a resilient market is not reacting.
• Coronavirus: stopped the real world economy – economic data deteriorated to Great Depression levels.
  • how much irreparable harm is caused, how much is a temporary slowdown in a solid economic environment that can be saved by stimulus?
  • Flattening curves are now visible worldwide, economies reopen and some fundamentals recover from extremely low levels = reason for initial relief rally, but a linear recovery is now priced in. Virus spread in the next weeks is crucial. 
  • Areas of resurgence are starting to appear, worldwide cases now rise significantly after a plateau.
  • Key question: economic slowdown vs. fiscal stimulus > what will be stronger?
  • Current Corona data

Further Outlook

• Uncertainty & lack of historic precedents makes forecasts extremely difficult: Follow systematic Meta Strategy = Bear Market environment (may change soon)
• Exogenous Shock Bear Markets: are short (avg 15 months) and shallow (avg 30% decline) historically 
• We are now in a decisive area for a possible positive market regime change
• Bear Market may still morph into longer recessionary bear market – pandemic may trigger overdue economic decline after longest bull market in history

TARGET AREAS FOR THE META STRATEGY DERIVATIVES PORTFOLIO

Long Targets	target reached	comment	target probability	derivatives exposure change*
2920 – 3040	yes	60MA to 275MA resistance cluster  and retracement = 62% of entire drop	extr. target
3400		all time high		wait and see

*size of the planned exposure changes = max. position / number of targets

Short Targets	target reached	comment	target probability	derivatives exposure change*
3000 – 3040		long term trend; zero gamma	min. target	reduce short
2780 – 2820		38% of rally; last minor low	main target	neutral**
2650 – 2700		50% of rally	max. target
2500 – 2570		62% of rally
2200 – 2350		March Low	extreme target
1960 – 2000		Lower Low

*size of the planned exposure changes = actual position / number of targets (= 1/2 at each target)
**reach neutral derivatives exposure – portfolio is exposed to long term ETF positions only

How to read the tables

• I maintain a list of targets on the up- and down- side. Whenever a target range is reached I change my probability estimate and derivatives exposure as indicated (max. position / number of targets = size of change at each target), because more extreme targets are less likely to be reached.
• At the minimum target I begin to reduce my derivatives position and put a mental break even stop loss on the remainder.

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 which leads to the return statistics in the monthly Meta Strategy newsletter.
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. (They 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: details for premium subscribers
  • planned portfolio adjustments:
  • maximum risk:
  • positions:
  • comment:

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

• Meta Strategy trading portfolio exposure: details for premium subscribers
  • planned portfolio adjustments:
  • maximum risk:
  • positions:
  • comment:

INTERESTING THINGS I READ THIS WEEK

• MacroChart: new article is a must read – he was on top of all major turning points over the last year.
• Put/Call ratio at extremes: analysis by Helene Meisler and myself
• Morgan Housel on being humble and finding things we can rely on in today’s environment

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 – be fair and do not distribute without my permission