What in the world does that title even mean? First, it's the name of what I regard as a very good book. Second, the basic idea is that carry trades have come to dominate global economies. Great. What's a carry trade?
A carry trade can be considered investing in anything that goes up over time. Traditionally, that was applied to slow-moving trades like currencies. For instance, you could borrow money in low yielding yen and investing in a higher-yielding asset. To skip to the end, what that ends up meaning is you're short volatility. As long as nothing changes too much, you should make steady money.
If you want to see a fruit fly version of this, where the cycle is really fast, look at crypto. People start off with something (relatively) boring like bitcoin. Then people leverage that to invest in more exciting things like dogecoins or NFTs or whatever until something down the line blows up, which causes a deleveraging up and down the chain. Bitcoin falls 75% or something and we start the cycle over again.
The author of The Rise of Carry says, and I agree, that at this point, the ultimate carry trade is in the S&P 500. Remember, a carry trade is fundamentally short volatility, so you get a version of the crypto treatment, where volatility gets suppressed until something makes it blow up to one extent or another. From a return perspective, that tends to mean strong returns punctuated with sharp losses.
Two other points should be mentioned. First, how do you make something inherently volatile like the stock market become less volatile? It's not my original idea, but I view the idea of thinking of the market as a seesaw is useful. If volatility happens somewhere in the market, you need to suppress it elsewhere to keep volatility level. The easiest way to do that is to sell volatility in large sources, like big cap tech, to suppress the natural volatility of the rest of the market. Over time, the tendency is for those large volatility centers to go up while the rest of the market meanders.
Second, of course, this system has limits. Occasionally something happens, like covid or war or inflation or whatever. This stresses the system to one extent or another. Like we see in crypto, though, it's hard to totally destroy the system. If you're curious, the authors think the best way to kill really this carry trade is sustained inflation.
This strikes me as the best way to think about the market we're in, now. The basic idea is a tendency to go up over time, but punctuated by sharp downward shocks, big and small.
Right now, we've had quite a party on hopes and expectations that the Fed and Treasury has and will continue to support this market. Breadth, how many stocks are participating in the rally, keeps getting narrower, though. Really, only three names (Nvidia, Apple, and Microsoft) are holding up the market while the average stock has gone nowhere since February or earlier.
Remember, carry trades are described by smooth gains punctuated by sharp losses. We've had great gains and are now unusually overextended. I've thought we'd have a retrenchment for about a month and that just hasn't happened.
Could the time be around now? I think you can make that case. Companies buying back stock have likely helped drive returns and the blackout period where they can't do that ahead of earnings starts around now. Perhaps for that reason, we've seen weakness around now in past quarters.
We also have the political crisis in Europe morphing into a potential financial crisis. Yes, it will get resolved eventually, but European stock and bond markets are pricing in worries while in the US, big tech is masking pain from Europe or anywhere else, really.
With sentiment and positioning still high, this doesn't seem like an ideal time to aggressively buy. At some point, the market will go down. Maybe that time is around now, maybe it isn't. For my part, I'm uncomfortable buying the overextended large tech sector, right now. In theory, we're in a logical position to rotate into beaten down areas like commodity producers, but I find it hard to get excited about much of anything, right now.
I'll talk more about positioning tomorrow, but I'm just going to sit back and watch for a bit. It is worth pointing out that, longer-term, the carry trade seems nowhere close to fully breaking. We can get a shock lower, but it should bounce back. That means eventually we want to buy future large volatility centers or associated names. I just fear our odds of a reversion is high, right now.
We'll see what happens this coming week. If we don't start to see a pullback in overstretched names, we'll probably have to find names to play along. Again, we'll see what the market tells us.