Volatility

Global Capitalism is trapped in its own Prisoner’s Dilemma; fourty four years after the end of the Bretton Woods System global central banks have manipulated the cost of risk in a competition of devaluation leading to a dangerous build up in debt and leverage, lower risk premiums, income disparity, and greater probability of tail events on both sides of the return distribution. Truth is being suppressed by the tools of money. Market behavior has now fully adapted to the expectation of pre-emptive central bank action to crisis creating a dangerous self-reflexivity and moral hazard. Volatility markets are warped in this new reality routinely exhibiting schizophrenic behavior. The tremendous growth of the short volatility complex across all assets, combined with self-reflexive investment strategies, are creating a dangerous ‘shadow convexity’ that will fuel the next hyper-crash.

"Real investors" are simultaneously nervous and hopeful, confident yet resigned. Yes, their basic belief in equities as an investment class is sound and supported by the last five years of good performance. At the same time, they understand the nuances of the bear case extremely well and are prepared for a long slog of lower returns.

26 years ago, today was envisioned as day when cars flew, holographic movies were box office hits, hoverboards roamed, and people were fired by fax. None of the happened. Instead the only "back to the future" moment this morning is a deja vu one we have seen every day for the past 7 years: bad economic news leading to surging stocks.

The recent bi-polar behavior in spot-VIX empirically supports the theory that a structural weakness now exists in this market by crowding of short volatility players. Short volatility sellers ridicule the fact that the prospectus for the iPath Long Volatility ST Index (VXX) clearly states that the ETF has an expected long-term return of zero. They should ask themselves, is it better to know with certainty you are going to go bankrupt slowly, or be completely ignorant of the fact you will go bankrupt suddenly.

On the basis of the fundamental economic backdrop, Goldman Sachs sees VIX fair-value at least 19, with low-teens more consistent with ISM in the upper 50s (not the current sub-50 levels). However, credit (and FX) protection markets imply significantly more risk ahead with CDX HY stalled at 2month lows (while VIX hits 3 month lows). Given historical relationships, credit markets suggest a VIX of 25 is more consistent with reality (especially as Skew tail risk rolls down to normal risk).

"Even though I had expected Q4 to contain lots of two-way volatility my expectation was generally for another risk-off quarter, and I felt that my S&P stop loss (weekly close above 2020 on the cash index) would afford me a prudent degree of cushion and comfort to absorb this expected two-way volatility. I did not expect such a strong risk-on move in response to such bad data!"

Investors are too complacent (the Minsky-Moment).  Too many are still trying to profit from the Fed subsidy of past stimulus. Investors remain loaded in risk assets, incentivized by the need to beat peers and benchmarks and comforted into complacency by the Fed ‘put’. The true level of risk is being ignored. The pervasive mentality of seeking maximum risk has become a terrible risk/reward trade for two main reasons...

After yesterday's closing ramp "prudently" just ahead of an abysmal IBM earnings report with the lowest revenues since 2002, and the latest rally in capital markets which sent European stocks to their highest level since August on the back of a barrage of global bad data which has unleashed the Pavlovian liquidity dogs screaming for moar central bank bailouts, this morning has seen a modest decline in the Stoxx 600 driven by energy names, while S&P500 futures are set to open lower on IBM's disappointment at least until the latest massive BOJ USDJPY buying spree sends the pair to 120 and the S&P solidly in the green. The biggest political event overnight was the Canadian election, where Trudeau's liberals swept PM Harper from power, capping the biggest political comeback in the country's history; the Canadian dollar is largely unchanged after initially weakening then rising.

News That Matters

The entire global financial system is leveraged to the 'Modern Portfolio Theory' concept that stocks and bonds are always anti-correlated. It is impossible to estimate how many trillions of dollars are managed according to the simple 60/40 mantras but let us just assume something north of $1.4 trillion and something south of "more money than God."  However, the truth about the long-term (132-year) historical relationship between stocks and bonds is scary.  The last three decades of extraordinary anti-correlation has been an era of falling rates, globalization, accommodative monetary policy, and very low volatility of CPI. With the global economy now at the zero bound, those days are over.

Another day, another "crackdown" by the CFTC on an "evil spoofing mastermind."

"This positioning squeeze should have now run its course. Both positioning analysis based on our proprietary flows and the CFTC data suggest that the market is now short USD and long risk for the yea. A further increase in risk appetite will depend on central bank action, starting with the ECB this week."

Despite the intense pain they are suffering in the low price Crudedome, both the Russian and Saudi governments profess for public consumption that they are committed to their volume and market share policies. This observer believes the two countries cannot long withstand the pain they have brought upon themselves - and this article only scratches the surface of the negative impact of low crude prices on their economies. They have, in effect, turned no pain no gain into intense pain no gain and set in motion the possibility neither will exit the low price Crudedome under its own power.