August 2024: Fasten your seat belts

Monthly update

Lever. If you blinked, you might have missed it. The tremors of volatility that characterized the second half of July permeated into early August. In a year that has been unusually calm, the major stock market averages experienced a swoon in the first week of the month. The lever is to blame.

Conventionally, when people think of leverage in the stock market, they think of broker loans called margin loans, where brokers’ clients borrow money to buy stocks, but that’s not the case here. The lever we are talking about may be foreign to you, it literally comes from Japan.

On August 5, Japan’s main stock index, the Nikkei, fell -12%, and in a sympathetic move, our most popular stock index, the S&P 500, fell -3%. Behind the scenes of this ongoing thriller was a so-called black swan event, the Japanese yen carries trade.

Essentially, a carry trade is a bit of financial engineering creativity where traders around the world borrow money in one country and buy securities in another country. Like any margin trade, the trader must earn more from the purchased securities than the cost of borrowing the money, the difference between these amounts is the profit.

A popular carry trade starts in Japan, a country that has historically maintained a low interest rate environment, allowing traders around the world to confidently borrow very cheap money from Japanese financial institutions.

These traders then buy securities from around the world. For example, a trader can borrow money at 1% in Japan and buy a US Treasury at 4% in the United States. All things being equal, the trader hopes to take home the 3% spread.

As of June, authorities in Japan estimated that nearly half a trillion dollars had been borrowed to finance these types of transactions—a sum so large that I had to do a double take on the screen!

That massive borrowing can wreak havoc on financial markets and partly explains how $6.4 trillion in global stock value was wiped out between the last two weeks of July and the first week of August as confidence in the trade faltered.

It also suggests that speculators were not only using their yen loans to buy safe assets such as Treasuries, but also the funds to buy stocks on margin – a very dangerous game.

In July, in response to economic pressures, particularly inflation, Japan’s central bank raised interest rates from 0.05% to 0.25% for the first time since 2007. Instantly, the yen carry trade with $450 billion in back became less profitable.

Then, just a few weeks later, the central bank signaled another hike in the coming months, and whoa! – the global system went berserk. So much so that the central bank had to quickly abandon that position or risk financial calamity.

For now, letting go of these comments seems to have calmed the markets, and combined with some positive economic news from the US, amazingly, global shares have not only recovered, but are up +8.8% from their lows in August.

Sometimes it seems like the stock market has the unimpressive memory of a goldfish. Just last week, Bank of Japan Governor Kazuo Ueda reiterated his willingness to raise rates to combat inflation, signaling that we may need to revisit this topic once again in the near future.

Above the Clouds

Our strategy thrives on these episodes of volatility, in fact, I don’t think it’s an exaggeration to say that our success depends on their regular occurrence. Fortunately, most of the time, volatility is the rule in the stock market, not the exception.

Essentially, our thesis is that insiders exploit their informational advantage over the rest of the market when they see their business heading north and their stock heading south. This mismatch happens less often when markets are steadily rising, but when the market foundation shakes, new opportunities inevitably emerge.

Contrary to their nature, insider activity returned quickly during the August selloff, and while sentiment never reached exuberant levels, it was enough to arm us with 13 new positions in a multitude of diverse industries and environments.

To name a few, in the semiconductor space, we took small positions in NXP (NXPI) and Mobileye Global (MBLY). In travel and leisure, I jumped into MGM Resorts (MGM). At the other end of the spectrum, we were pleased to pick up Energy Transfer LP ( ET ) and Clearway Energy Inc . (CWEN) from the utilities category.

The breadth and underrepresentation in the S&P 500 of these new positions is what we rely on to ensure our returns remain stable, above average and less correlated to broader indices.

Second, these bursts of volatility allow us to flex our risk management skills. Our quantitative framework consistently ensures the risk environment in which we operate. Using a multitude of data points such as macro insider sentiment, economic indicators and valuation, we view the world on a risk continuum and allocate our partner capital accordingly.

This approach has helped insulate us during the worst of the market selloff and allowed us to deploy that marginal capital in our new and existing positions at what we consider extremely favorable prices.

As a result of the market turbulence in August, our reserve fell from around 16% of assets to less than 11% at the low end. Currently, as volatility has decreased, valuations have recovered and insider activity has decreased. Accordingly, we are taking measured steps to increase our reserve.

This powerful combination of insider signals and reserved capital has helped us successfully navigate all types of market volatility. For marketers who are heavily leveraged or carry trades, market volatility is not only dangerous, it can be disastrous.

For us, our process harmonizes volatility to our advantage, looking for opportunities in the chaos. We planted a lot of seeds in August and look forward to seeing them bloom in the coming months, but we remain vigilant to market risks and look forward to updating you again in October.

How it works

Objective: Predictive model that measures the historical relationship between insider sentiment and the future probability of downside volatility (risk).

Insider trading activity: An insider’s own stock buying activity filtered by proprietary parameters to clean noisy data.

Perspective: Executive sentiment is an indicator of short-term financial market risk.

– Low executive sentiment suggests a high level of risk.

– High executive sentiment suggests a low level of risk.

Scale: A report of current insider trading activity against historical patterns.

– (0 to ∞) with a historical median measure of 1.

– Below 1 implies an above normal level of risk.

– Above 1 implies a below normal level of risk.

Frequency: The measure is updated daily and has been subject to rapid and possibly extreme changes in the past.

*This web page is updated monthly and only provides an image of the most recent month end.

Disclosures

This presentation does not constitute investment advice or a recommendation. The publisher of this report, CDT Capital Management, LLC (“CDT”) is not a registered investment advisor. In addition, the presentation does not constitute an offer to sell or the solicitation of an offer to buy interests in the advised fund of CDT, CDT Capital VNAV, LLC (the “Fund”) or related entities and may not be relied upon in connection with the purchase. or sale of any collateral. Any offer or solicitation of an offer to purchase an interest in the Fund or its affiliates will be made only by delivery of a detailed term, an amended and restated limited liability company agreement and a subscription agreement, which collectively contain a description of the material. terms (including, without limitation, risk factors, conflicts of interest and fees and charges) relating to such investment and only in those jurisdictions where permitted by applicable law. You are cautioned not to use this information as a basis for making a decision to purchase any warranty.

Certain information, opinions and statistics relating to the industry and general market trends and conditions contained in this presentation have been obtained or derived from third-party sources believed to be reliable, but CDT or its affiliated entities represent that such information is accurate or complete. . You should not rely on this presentation as the basis on which to make any investment decision. To the extent that you rely on this presentation in connection with any investment decision, you do so at your own risk. This presentation does not purport to be complete with respect to any subject covered. The information in this presentation is provided to you as of the date(s) indicated, and CDT intends to update the information after it is distributed, even if the information becomes materially inaccurate. Certain information contained in this presentation includes calculations or figures that have been prepared internally and have not been audited or verified by a third party. The use of different methods of preparation, calculation or presentation of information may result in different results, and such differences may be material.

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Editor’s note: The abstracts for this article were chosen by the editors of Seeking Alpha.