Many people remember The Big Short, the film inspired by the big financial crisis of 2007-2008, in which the protagonist took increasing short positions having assessed that the subprime market was in a bubble and the mortgage backed securities (MBS) tranches, evaluated with triple A, were also at risk.
Recent studies have shown that, even the short positions taken were not risk-free at that stage. Today, the Major indices (we are in the eleventh year of equity growth) are configuring a textbook situation: how take advantage of an extreme market situation? What are the related risks?
The first alternative is to go short for as long as necessary until the trend reverses. This approach implies a relevant cost of carry, both for the duration and for the cost of renting the securities to be sold short plus the interest rate. In this case, the risk, as John Maynard Keynes puts it, is that "markets may remain irrational longer than your ability to remain solvent". If you then decide to enter in the short position with an OTC derivative, you must take into account the risk / cost of illiquidity and in extreme cases, of the counterpart (Lehman is the most famous case). As happened in 2008, the counterpart that sold the product may go bankrupt or there may simply be a collapse of confidence in the counterparts which drains the market (pre-Lehman situation).
The second alternative, towards which in 2007-2008 many people turned and which today is preferred by Simplify 02, is to buy the most aggressive assets and at the same time, buy volatility when this is less desired or deemed useful. In 2021, for the moment, market reversals are VAR shocks, or isolated cases caused by specific events and they are destined to be overcome and mainly concerning equity. In cases of VAR shock, Simplify 02 prefers to allocate an increasing share of the volatility index (VIX - curve permitting) in the periods in which it is pushed down by systematic sellers, but, even this window is now closing (the average is no longer 12/14 but 22/24). In 2007, this technique was applied by purchasing the junior tranches of MBS with double-digit positive returns but at risk of failure and at the same time buying credit default swaps (CDS) of the senior tranches counting on the fact that the bursting of the bubble would have caused the bankruptcy of junior AND senior tranches. This approach has a lower risk profile than the naked short of the first alternative because until the negative shock occurs, the positive carry is collected with an insignificant or almost insignificant negative cost of carry of the short. Similarly today, until the shock occurs, the market trend is positive with a lower cost of carry of the volatility index. At worst, the trade break-evens. In 2008, as highlighted very well in The Big Short, only few people were able to see what seemed impossible: even in the phase of market collapse, the price of the most illiquid tranches of OTC credit default swaps (CDS) did not move at first because there were not exchanges with the risk of causing the failure of those on the right side of the trade because the long tranche was discharged by everyone while the counterparts did everything to not move the price of the protection (often an CDS OTC).
Finally, a third alternative, more viable alternative is to wait patiently, with plenty of cash available, for the bubble to burst and as Simplify02 did in 2009, buy the fragments of the broken market and enjoy the benefits of the recovery (in 2008 Simplify02 achieved a positive performance of 37%). We are partially applying this approach by remaining partially under invested and bearing the burden of passive carry of having cash on hand. But specially, starting to buy when no one is going to do that and the current narrative is that finance is over.
Today, the current narrative on the markets, is a gradual growth of the economy to pre-Covid levels, distributed in a new way across sectors and a gradual success of central banks in creating inflation (reflation trade). At the moment this is the signal that the market is giving: an increasingly steep rate curve and an interest that declines for longer maturities.
What could change this current narrative? In our opinion:
a) the awareness that the Covid crisis is here to stay and will impose a lasting burden on the economy;
b) governments fail, cannot or do not want to continue to keep the affected economic sectors alive at all costs and therefore let some companies fail (the German travel company TUI is on the third bailout of the government: will it continue like this?) allowing the "destructive creativity" of capitalism to run its course;
c) the fall of one of the dominoes and the fear of a domino effect.
Meanwhile, evidence of the extreme limit reached by some situations has reduced the number of short positions. The case of Gamestop gave a strong and clear signal to short sellers: if you pull it too much, the rope sooner or later breaks. Let's remember that the disappearance of short sellers in a market situation at the highest is not necessarily a good thing. As we have seen, short sellers bear a cost until the market rises and in the event of a negative shock, sooner or later they buy to close their positions putting a brake on the bottom of the market.