Risk: Off

Dear investors,

 

In recent weeks, we have witnessed significant turbulence across global markets, with a notable correction in the Nasdaq, a spike in the CBOE Volatility Index, and increased attention to the so-called “Yen Carry Trade”, which has had a substantial effect on the Japanese stock market itself. These developments underscore the complexities and interconnectedness of today’s financial landscape, where shifts in one region can ripple across the globe.

 

At the opening bell on Monday, August 5^th, the S&P 500 gapped down 3.65 percent, following a massive selloff in the Japanese equity market the previous night. The country’s Nikkei 225 Index collapsed a calamitous 12.4 percent to start the week, locking in the largest single-day selloff since October 1987, and pushing the index into a 26 percent drawdown from its all-time-high just last month.

 

 

The recent crash has been attributed to the Yen Carry Trade, a popular investment strategy where global investors borrow money in a low-interest rate economy, such as Japan, and convert the currency to that of their home country to invest in higher yielding assets. In theory, this can be a promising strategy. However, like any investment strategy it does not come without risk. The Carry Trade operates on an expectation of relatively stable exchange rates and predictable interest rates.

 

Since 2012, the Japanese Yen has depreciated substantially against the US Dollar, with 1 greenback being equal to approximately 162¥ at the peak of July. Compared to the Dollar, the Yen has not been cheaper since the early 90’s.

 

 

Those that have borrowed in Yen and invested in risk-on assets in the U.S market have done extremely well over the last several years, thanks to both the magnificent bull market we’ve witnessed in large-cap stocks and the appreciation in the Dollar against the Yen. These combined movements are ideal for those institutions participating in this strategy, but the risk lies in a sudden appreciation of the Yen against the Dollar, which will force investors to sell their U.S assets to repay their Yen-denominated loans. This is exactly what we have witnessed over the last several weeks and has been covered by the financial media being referenced as The Unwinding of the Carry Trade.

 

The stock market fear gauge, more officially known as the CBOE Volatility Index, or “VIX”, saw a sudden spike on August 5^th, pushing above 60, a level we haven’t seen since the start of the 2020 pandemic.

 

 

The VIX is a measure of the aggregate implied volatility of a series of S&P 500 Index options, which serves as an estimate of the volatility of the stock market over the next year. A VIX reading of 60, as we got last week, indicates that options traders were pricing in extreme short-term volatility, annualized to equal 60%. This figure represents a one standard deviation move, so based on options prices at this time the market was factoring in a 68% probability of a 60% move in either direction over the next year. In fact, within the first few minutes of the market open Monday morning, traders were briefly factoring in approximately a 10% probability of a 20% crash the next day. Even in the face of a crash in Japan and a correction in the U.S, these probabilities seem ludicrous, and quick traders were able to benefit by selling this overpriced implied volatility by shorting options at apparently elevated prices.

 

To the relief of Wall Street and most long-term investors, the opening on Monday turned out to be the bottom of the market – at least for now. There is no certainty in whether or not the correction in United States equities is over, but in just the last week there has been a serious shift to risk off assets. In the time equities have sold off, investors have fled to quality in government securities, decreasing yields in 10-year treasuries by over 30 basis points. This has caused popular treasury-linked ETFs to perk above their long-term moving averages, indicating what could be a potential change in trend after a tumultuous few years for the fixed-income market as a whole.

 

 

The recent rotation has revived the question of whether or not the U.S is actually on the brink of a recession. What is normally defined officially as two consecutive quarters of a decrease in GDP is often led by market selloffs and rising unemployment. The Sahm Rule has also gotten increased attention since last week’s unemployment numbers came in higher than expected at 4.3% compared to an estimated 4.1%. The Sahm Rule states when the three-month moving average of the unemployment rate rises by more than 0.5% from its trailing twelve-month low, the economy is in the early stages of a recession. Although not definitive by any means, the rule created by Claudia Sahm has predicted every recession since 1970, including the recessions of 1974, 1980, 1981-1982, 1990-1991, 2001, 2008-2009, and the brief 2020 recession caused by the COVID-19 pandemic.

 

 

The long time JP Morgan CEO, Jamie Dimon, has also stated on several occasions that he sees the possibility of an upcoming recession to be increasingly likely. JP Morgan economists now expect a 35% chance of a recession by the end of the year, 10% higher than their expectations from July.

 

However, equally brilliant economists, including Sahm herself, have admitted that this may be the first false positive generated by her indicator. Jerome Powell was asked about this in the latest Fed meeting and cited that the market has seen a number of failed indicators over the last few years that are normally very reliable in predicting economic downturns, including the concern over the inverted yield curve that has not yet been followed by a recession.

 

 

Navigating a complex market with conflicting signals like today’s comes with unique challenges, but equally great opportunities. As Peter Lynch reminds us, sometimes the market goes down. A correction (usually defined by a 10% or greater drawdown) can be expected every two years, and a more serious decline (25% or more) can be expected every six years. When the market slides to that degree people will claim that they predicted it, but it took 53 predictions for them to get it right.

 

At Sonic Capital, our flexible mandate and nimble nature allows us to slip in and out of positions to potentially capitalize on both bull and bear markets, while maintaining a long-term beta positive bias. By utilizing equity derivatives and relatively simple options strategies, it is possible to protect against massive selloffs by purchasing low implied volatility deep in-the-money puts. Although that type of positioning would get hurt in the event of a massive recovery in the stock market, it stands to perform better than outright short positions, having risked only the premium to buy the options.

 

Biotechnology

 

While we’re not yet considering it a core theme within Sonic’s larger portfolio, biotech stocks have started to look more and more appealing. Pharmaceuticals and small cap biotechnology companies individually are very risky endeavors because their long-term success is often determined at the mercy of the Food and Drug Administration. Large daily moves follow overnight news of FDA approvals or denials of drugs, the latter being the outcome far more often than not, making it nearly impossible to pick a winning lottery ticket out of the vast sea of emerging biopharma businesses.

 

In aggregate though, biotechs go through periods of extended bull and bear periods, just as any other industry would. Uniquely, however, the healthcare sector is considered defensive because of the ongoing demand for their products regardless of economic conditions. Depending on the exact nature of a downturn, this sometimes allows the sector to outperform the market as a whole in massive corrections, even though they would often be considered the riskier component of the market in regular conditions.

 

 

From the industry’s peak in early 2021 to the 2022 trough, the S&P Biotech ETF (ARCA: XBI) forfeited 64% of its value, falling from $174 to $63, almost precisely tagging its 2020 low before witnessing a relieving bounce.

 

 

Another testament to the sentiment in the industry comes from analyzing the underlying fundamentals of a sample of companies within the biotech universe. Certain companies, while not generating consistent revenue, seem to have tremendously strong balance sheets, with many cases of stocks trading at a fraction of their working capital, or occasional market caps less than their cash position alone, even after subtracting all liabilities. For a single company, this usually comes as a result of high operating expenses and the market’s expectation of management burning cash to fund their research and development. In this industry, high R&D expenses are common practice, and a firm’s inability to generate enough cash to fund these operations is what often leads to their failure. When too high a percentage of companies within the industry trade at discounts this steep though, it says something about the industry as a whole, without the need to select individual winners within the sector so long as a diversified basket is purchased in place of it.

 

An Update on Cannabis

 

One area of the market that continues to be overlooked by large institutions is the growing Cannabis industry. As of 2024, the use of recreational cannabis is legal in 24 states and is legal for medical use in another 14. Additionally, several of the larger producers have reported quarterly financial results in the last week, with many reporting revenues above consensus estimates citing the recent legalization in Germany as a major contributor and area of serious potential growth.

 

And, in the dawn of an upcoming election, legalization at the federal level in the United States has become a popular subject among both the Republican Nominee, Donald Trump, and his democratic counterparty, Kamala Harris. Harris, having primarily liberal views has expressed support for the federal legalization of the substance, and although Trump’s official position has been somewhat ambiguous since his 2016 campaign, it seems his views have evolved to be more in favor of legalization.

 

At a press conference last week, Trump was asked by a reporter about his stance on marijuana and Harris’ opinion on its decriminalization. He replied, “as we legalize it, I start to agree a lot more.” He went on to insinuate that he will be making a more official announcement on his position in the near future. On the day of this statement, the AvisorShares Cannabis ETF (ARCA: MSOS) saw a 10% jump, despite still being down approximately 35% from its April high on the rumor of it being reclassified to a schedule III substance. In the last two months, the DEA has made no progress on officially updating its classification, which is what has largely been attributed to the declining stock prices of these niche companies.

 

Even some of the more well-known operators in the space are down incredible amounts from their all-time highs. Canopy Growth Corporation reached a peak market value of just under US$20 billion in February 2021. Today, their market capitalization stands at just over US$700M, representing a decline of approximately 96% from just three years ago.

 

 

In our view, and regardless of the outcome of the November election, any reform can only be positive. Neither president would be in favor of recriminalizing the substance, and it seems the worst-case scenario from a legislative perspective would be that even if it remains illegal at the Federal level, it would still be left up to the states to legalize it on a case-by-case basis.

 

The continued acceptance within the states and the growing international market has been part of the reason behind Wall Street analysts’ expectations of growing revenue over the next several years. Canopy Growth is one of the few cannabis companies that maintains a dual listing on the Nasdaq and has liquid options available to traders willing to speculate in a stock with extreme volatility. Applied thoughtfully though, options can offer a way to get full or partial upside exposure to a stock while only risking the net debit paid, which is typically just a fraction of the underlying share price.

 

But in recent months, CGC options have exhibited some unique behavior. Typically, call and put options with strikes equidistant from the current market price should be very close in value. This is due to the concept of put-call parity, which allows sophisticated traders to replicate certain options positions by taking outright positions in the underlying combined with a second leg in the form of a long or short option. A long-call option, for instance, could be replicated by purchasing the underlying stock and a put contract simultaneously, thus capping the investor’s downside while allowing them the full upside potential, in return for a small premium. Similarly, a long put can be replicated by shorting stock and buying a call option, protecting them in the event of a massive increase in stock price, while also allowing them to benefit if the stock moves down.

 

In some cases though, shares are hard to borrow and interest rates can affect a trader’s ability to go short. This can lead to the price of put options being bid up relative to their corresponding calls, thus creating what is known as a skew in the option prices.

 

*Source: Charles Schwab, as of August 12th, 2024

 

Notice the differences in implied volatility between the January 26 put options and the call options of the same date. The puts show a substantially higher implied volatility indicating that the market is pricing in a higher probability of a significant downward move than an upward move. Although this may appear scary for a bullish investor, this is a classic contrarian setup – going against the crowd with the expectation that any negative sentiment is already accounted for in the underlying price.

 

If implied volatility were to normalize between the different option types, these long-term call options would be expected to see a massive increase in value from a vol expansion alone, even if the underlying were to stay at approximately the same price. Today, their theoretical value is very close to their traded value based on options pricing models’ predicted values, but we can use the same model to estimate how much a change in implied volatility would impact the price to select those options that appear to have the greatest multiple potential.

 

Astute analysts may notice the relatively high open interest in call options, the $10 strike currently having 12,414 contracts outstanding, representing notional exposure to 1,241,400 shares, or approximately $8.2M in underlying value, using today’s intraday share price of $6.57. An $8.2M investment is not extremely sizeable for an average financial institution or even in terms of the company’s own market cap. But to sell such a high number of contracts in the form of covered calls seems highly unlikely. Why would anyone risk holding shares of a volatile stock for over a year to take in such a small premium and maintain the risk of the shares falling substantially in value? It is our opinion that a vast majority of these contracts, and those above the $10 strike price, are being sold naked, indicating that traders are selling calls without the underlying shares to back them up. Unlike naked shorting a stock directly, there is nothing illegal or even unethical about selling naked call options, so long as the account holding the short contracts has the margin available to take on the position. This does, however, leave the seller with theoretically unlimited risk if the stock were to increase substantially in value. If the stock were to experience a sudden and sharp move to the upside, the sellers of these options may be forced to cover or close out their positions at the discretion of their broker if their amount at risk grows too large. To the option sellers, positions can be de-risked by buying back the call options themselves, thus pushing up the call prices, or by buying the underlying stock directly and pushing up the share price and therefore the call options by extension. This is very similar to a traditional short squeeze where, when short interest gets too high, a small move to the upside can spark a frenzy of buying to limit risk, pushing prices higher, triggering more margin calls and more forced buying.

 

In terms of the company’s float though (approximately 85M shares), notional short exposure to 1.2M shares is hardly significant and would be unlikely to push the price up by itself, at least to any significant extent. Still, this is an interesting observation that will be worth keeping an eye on if open interest were to continue growing in the form of naked call selling.

 

The combined possibility of legislative improvements, international expansion, and the quantitative elements available in the options market make this a very compelling setup for accounts with a high willingness and ability to take risks. Although the risk/reward characteristics seem to support this type of position, it should be emphasized that buying out-of-the-money options on a highly volatile stock comes with a serious chance of losing the entire principal if the stock were to decline, or simply not rise in price enough between today and the option’s expiration.

 

 

Sin stocks refer to companies that operate in industries that are often considered morally or ethically controversial and typically include tobacco, alcohol, adult entertainment, and more recently since its growing legalization, cannabis. These certainly don’t belong in every portfolio, but there is a clear benefit to them that’s not witnessed in every area of the market. Historically, sin stocks have performed well, at least relative to the overall market, in times of economic turmoil. Altria Group, originally known as Philip Morris before their 2003 rebranding, is one of the largest tobacco companies in the United States and the producer of the famous Marlboro brand cigarettes. The company has outperformed the S&P 500 on a dividend-adjusted basis through every recession going back to the 1970s. This is generally attributed to the company’s inelastic demand for their products, high profit margins, and stable cash flows.[1] Although many of these qualities do not yet apply to most of the cannabis industry, their products do serve as a coping mechanism in times of economic hardship. The use of tobacco, alcohol, and cannabis helps people deal with stress in the face of uncertainty, and we believe there is a very reasonable expectation of continued demand regardless of the short-term macro environment. As we witnessed last Monday, and as history teaches us, in times of panic the short-term correlation of most investments approaches 1. However, after the market has had time to digest new information and the initial selloff subsides, correlations begin to diverge once again, leading to improved benefits of diversification.

 

Countless variables will affect whether or not our thesis will play out as expected. Although our current positioning has been detailed throughout this letter, it is our job to change and adapt to the market as new information comes to light. It is a fool’s game to force a position to work when the market is giving you clear signs otherwise. But given the current climate, we believe new opportunities will constantly be arising and our portfolio will continue to change along with the market.

 

 

Sincerely,

Maxwell Fischer

Investment and Trading Analyst

 

[1] Altria Group, Inc was selected as an example to estimate the performance of sin stocks simply because long-term data for a larger sample of companies to represent the industry is not readily available. The stock’s trading history goes back through numerous economic recessions and stock market crashes and is meant to be an example to demonstrate our point. This does introduce an element of survivorship bias and is not necessarily representative of all the different types of sin stocks.