Will 2017 See Peak Fragility?

Tyler Durden's picture

Markets remain more fragile than today’s volatility levels suggest according to BofAML's global equity derivatives group.

This fragility has been driven by:

  • Central bank dominance: Markets’ overdependence on central bank policy suppresses risk and reduces the breadth of factors driving asset returns. This starves the market for alpha, leads to excessive crowding (as more capital is chasing fewer opportunities), reduces investor conviction and increases the risk of tantrums. This reduced conviction has also contributed to investors running high cash levels and adopting the buy-the-dip strategy which has contributed to the record reversals in volatility as well.
  • Failing liquidity: Due to both regulatory change impacting banks and increasing risk-aversion among high frequency market makers, liquidity has been drying up at record speed during times of stress.

While our Fragility Indicator, based on the number of cross-asset shocks recorded over a 6-month window, has been declining since early 2016, our short-term fragility indicator has recently spiked to the 95th percentile since 2000 following Trump’s US election win, and this event set a record in terms of the S&P jumping from extreme intra-day volatility to calm as investors rushed to buy the dip.

While we don’t expect this fragility affliction to reverse near-term, if higher inflation pushes rates higher and reduces the Fed’s ability to micro-manage the market, this would remove one of the key pillars of fragility.

And while it still only a possibility, if regulation which has helped cause trading liquidity to dry-up is reversed, it would only further alleviate today’s fragile condition. In other words, the more the “new normal” becomes more like the old normal, the less fragile markets should become.

The “old normal” equals more alpha for active managers

Active managers have recorded among their poorest performance recently in this era of high fragility.

Chart 12 shows that hedge funds have recorded very poor performance, exhibiting in 2016 their largest drawdown relative to the risk they are running in any period outside of 2008. Similarly, the lowest percentage of large cap US active equity managers has outperformed their benchmark this year since 2003 according to data from our equity strategists. This is despite one measure of active alpha potential, which historically has correlated well to active manager performance, rising steadily since 2013 (Chart 11).

This would suggest the reason active managers have underperformed is not due to a lack of potential market opportunity, rather due to the drivers of returns shifting away from traditional fundamental factors to things such as position crowding, CB intervention and momentum vs. mean reversion – all hallmarks of a fragile market.

Active opportunity rising but so is the risk

Since the US election, as the market has begun to rapidly differentiate between winners and losers from potential fiscal stimulus and inflation, sector dispersion relative to the level of market volatility has risen dramatically to the 96th percentile since 1990 (Chart 13).

While this represents significant opportunity for active managers to outperform, it also represents significant risks if the strong deflation to inflation rotation reverses on fiscal stimulus disappointment. Hence, we think using cheap option based strategies for capturing this potential while limiting the risks is prudent.

*  *  *

So it appears events are creating greater and greater 'fragility' but the common knowledge of an omniscient central bank put also accelerates the mean-reversion of that fragility, and yet BofA hopes that breaking the chain of central bank dependence (and perhaps improved liquidity) will normalize fragility in the markets. We suspect not.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
buzzsaw99's picture

Friends, ZHers, countrymen, lend me your ears;
I come to bury alpha, not to praise it.
The evil that alpha does lives after it;
The assets oft interred with long dead hedge funds;
So let it be with the dearth of alpha...

Dragon HAwk's picture

Too many people betting on which way the cart is going to bounce, instead of helping load or push the cart

jamesmmu's picture

DOW up 300pts today, future still not red. even ZH can't scare them anymore.

chicken_goose's picture

The stock market is so overvalued right now that as soon as any heaving selling starts it will become a self-sustaining push downwards as over-exposed stock-holders dump their positions on the market to avoid losing the majority of their portfolio value. Yeah sure CBs can jawbone the market higher but eventually that doesn't work, they cannot defeat the business cycle - this market is going to lose a huge percentage over the next year or so and the only way for CBs to stop it will be for them to print to oblivion causing hyper-inflation.

CHoward's picture

Within 24 hours of Donald Trump being sworn in as president - the scumbags in charge (today) will walk away and trash all the life support systems falsely holding up this pathetic system.  They're just waiting for Obama to exist - can't make him look bad.  Wise people will know what happened and who to hold responsible though.  Trump has NOTHING to do with this bullshit.