Red Light Cycles
Vol #148: September 28th, 2023
State changes require energy. The transition from solid to liquid or liquid to gas moves along as more and more heat is added. Quite a bit simpler than the will to improve ourselves.
To speed up the atoms and overcome friction we need some power source. At a greater-than-molecular level, the cost that comes with any shift is both a mental and physical question. After ripping down the highway, turning onto a local road requires a very minor tweak in the angle of your right foot. Yet there’s a fairly significant realignment of your eyeballs and bio-CPU to adjust to the new pace of flying objects.
Triathletes know well the difficulty of the “brick” - a dreaded cardio conversion from two wheels to two feet. After fighting through a laundry machine swim experience, a nice bike ride gets competitors into a groove before they have to switch from spinning gears to putting one foot in front of the other. This is multiple rungs more difficult than it seems.
Even with a trusty almanac, and the capacity to handle all weather conditions, the toughest outdoorsmen still get a sniffle when the seasons start to tip over. Change is hard, especially when it’s unpredictable.
If you’re cruising along ten clicks over the speed limit, that deep orange shade of a yellow light waxing is going to be all the more painful to accept. The slam of the brakes and the consequential seconds that follow are mechanically and emotionally grueling. The length of a red light is the same whether you pull up at 60 or 16 miles per hour. But where you arrive from, matters.
Path dependence is where you flip a coin ten times and get five heads then five tails. The sample mean is smack in the middle of the bell curve, but the experience is a one in a thousand. If you were an asset manager, after the first 5 flips you’d have launched a $100M fund.
How investments feel is an incredibly important part of the psychology of investing. As we wrap the third quarter this week, while notionally the SPX is only down roughly 3.5% (hold your beers until Friday’s close) from peak to yesterday’s trough we’re down twice that. What’s worse is that two thirds of that loss has come in the fateful days since the 21st night of September.
Blood in the streets? Hardly. Did something change? It feels like it, but probably not. This is EXACTLY what the markets predicted would happen a month ago. Swim, bike, and run happened, but not at all like how your training went.
Those three little orange bars on the right? That’s saying that even though the last week has been choppy, thirty days ago the ATM vol expected 13.1% movement, and the realized (historical) volatility was about 12.7% over that period. A pretty good guess considering the most liquid index in the country consistently trends between a 1-2 percentage point premium.
The volatility (variance) risk premium (VRP) is the difference between how much we think markets are going to move, and how much they actually move. It’s a backward looking indicator, so no drawing of support lines or calling a local bottom. It doesn’t even really measure the payout of any given options strategy. For the most part that’s going to have a strong delta component - VRP aside the trade was definitely to be short calls, long puts.
VRP is a measure of market efficiency - is the broad community appropriately pricing forward looking distributions? Our brains expect randomness to be more structured than it is - i.e. we think patterned noise is random, whereas true randomness is wild and unbounded with a lot of streakiness. The path the market took over those thirty days feels like that hot hand set of coin flips. Up, up, up, down, up. Down, up, down, down, down.
When coin flips or stock ticks are going against you, the cognitive dissonance is an unyielding sledgehammer on all that is reasonable. It’s the pain of jamming out the final days of September with Earth Wind and Fire, only to be jammed up at an empty crossroads staring at a big red circle.
In simplistic terms, the S&P 500 is up about 3 years in 4. Over time that actually translates to roughly approximate weekly and monthly red/green figures. The kicker of course is how much it’s up or down. But regardless of what the net figures are, the emotional abacus tallies in simple counts.
Investors for the long haul will see lots of traffic lights. Unlike the stylized example though, it won’t come evenly. There are long stretches of rural roads where nothing happens and you put miles in the log book, followed by non stop crosswalks and stop signs through the intersections of bustling village centers.
If I told you the light was green for 30 seconds and red for 10 seconds, that sounds pretty easy to handle. Kind of like the market up 3 out of 4 years. On average you only end up waiting for 5 seconds. And if you’re five seconds out from a green light, there’s only a 16% chance it turns red before you get there. Just like the market has returned 8% a year for the past century.
Traffic light waiting times are the bell curve of real world examples. They aren't even as complicated as modeling the vehicles that flows underneath the torches - that requires the Poisson distribution from a few chapters down the road.
Investment returns are even more brain melting. The reason skew exists is because of the kurtosis of the return profile. Volatility is not normally distributed, and the pockets of crazy come all at once or never at all. Sitting on your hands during a red light market is difficult. We don’t know when it will end, and can only lean on the fact that it usually does.
Patiently counting on change is the ultimate cookie test. The market goes through phases where things are good and bad, and opportunity is variously scarce. Yet even if what happens is exactly what the market collectively expected, it never happens in the way we individually imagined. Anyways, does winter coming a week earlier or later this year cause you to start seriously browsing Zillow?
Next time you’re stuck waiting at a traffic light, appreciate how much easier it is to be calm with a predictable process, and give yourself a break for your impetuous trading decisions. Change isn’t always what it seems.