Deutsche Bank: The Market's Current "Metastability" Will Lead To "Cataclysmic Events"

Tyler Durden's picture

With the VIX slammed at the close of trading on "quad-witch" Friday, sending it just shy of single-digits once again and pushing stocks back in the green in the last seconds of trading, the much discussed topic of (near) record low volatility simply refuses to go away, which means even more attempts to i) explain it, ii) predict what ends the current regime of "endemic complacency" and iii) forecast the "catastrophic" damage to markets when it does finally end as JPM's Kolanovic did earlier this week, when he set the bogey on a modest increase in the VIX from 10 to just 15.

Overnight, applying his typical James Joycean, stream-of-consciousness approach to capital markets, Deutche Bank's derivatives analyst Aleksandar Kocic penned his latest metaphysical essay on this topic, which covered most of the above bases, and which postulates that far from "stable" the current market equilibrium is one which can be described as "metastable", the result of widespread complacency, and which he compares to an avalanche:"a totally innocuous event can trigger a cataclysmic event (e.g. a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche."

He also inverts the conventionally accepted paradigm that lack of volatility means lack of uncertainty, and writes that to the contrary, it is the ubiquitous prevalence of uncertainty that has allowed vol to plunge to its recent all time lows, keeping markets "metastable."

How does the regime change from the current "metastable" regime to an "unstable" one? To Kocic the transition will take place when uncertainty, for whatever reason, is eliminated: "Big changes threaten to explode not when uncertainty begins to rise, but when it is withdrawn." He also points out that while there is punishment for those who seek to defect from a "complacent regime"...

Complacency encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which further reinforces bad behavior. This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems. Complacency arises either when everyone agrees with everyone else or when no one agrees with anyone. In these situations, which capture the two modes of recent market trading, current and the QE period, the markets become calm and volatility selling and carry strategies define the trading landscape. But, calm makes us worry, and persistent worrying causes fear, and fear tends to be reinforcing.

... such "metastability" is in itself unstable: "Persistence of low volatility causes misallocation of capital. This is how complacency leads to buildup of risk – it is the avalanche waiting to happen."

Unlike Kolanovic who quantifies the "metastable" regime's thresholds in terms of VIX (warning of catastrophic losses for vol sellers once VIX rises above 15), Kocic instead merely qualifies the factors that build up in the final phase of the "metastable" regime, eventually spilling over (as shown in the chart above), forcing its end in a violent burst of volatility (and a market crash):

Endemic complacency, which continues to take hold of the markets, is likely to play an increasingly adverse role the longer markets continue to operate as they recently have. However, although volatility remains depressed, the risk continues to be pushed to the tails. This is a buildup of metastablity. The longer the stick remains still, the more surely it will fall.

The simplest analogy to "Austrians" like Mark Spitznagel, is the lack of controlled "forest fires" to eliminate old trees (i.e., systemic excess and "zombie corporations" from central bank intervention and record liquidity), ultimately resulting in a catastrophic conflagration of epic proportions -  a lack of "creative destruction" sowing the seeds of the system's collapse, as Schumpeter would put it:

In the financial forests of our own making, suppression is particularly problematic — and even deadly. Excess and malinvestment thrive for a time, only to be destroyed by ravages caused by their own vulnerability. Yet, as we will see, even such high-intensity "fires" (of the forest and financial varieties) will has up and redistribute resources; in the case of the market, it releases capital to areas previously avoided the to the myopic distortions of monetary intervention. (The Austrian School naturally understood this well, as explained by the Austrian Business Cycle Theory.)

To Kocic, the natural equivalent is an avalanche. Whether one uses a raging inferno, however, or an avalanche as the analogy of what will eventually happen to the market, the message is clear - every passing day that the market remains "metastable" adds to the violent whiplash that will be unleashed once markets inevitable revert back to their "unstable" disequilibirum in the near future.

* * *

Below we excerpt select sections from Kocic's full essay:

Metastability

Big changes threaten to explode not when uncertainty begins to rise, but when it is withdrawn. Excessive determinism is almost always the biggest enemy of stability. This seeming contradiction is behind the concept of metastability which captures the mode of market functioning in the last years.

Imagine you have to balance a long stick on your finger. By placing it vertically on your fingertip, the stick could fall either left or right from its initial position because standing upright is unstable. However, in trying to keep the stick vertical, you instinctively (and randomly) wiggle your finger. The added randomness (noise) acts as a stabilizer of an otherwise unstable equilibrium. So long as the noise is administered carefully, the stick remains vertical, or metastable. The withdrawal of noise becomes destabilizing.

In general, there are three types of equilibria to distinguish: stable, unstable and metastable. The bottom of the valley is stable; top of the hill is unstable; a dimple at the top of the hill is metastable (Fig). Metastability is what seems stable, but is not -- a stable waiting for something to happen. Avalanche is a good example of metastability to keep in mind -- a totally innocuous event can trigger a cataclysmic event (e.g. a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche).

Complacency is a source of metastability. It has a moral hazard inscribed into it. Complacency encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which  further reinforces bad behavior. This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems. Complacency arises either when everyone agrees with everyone else or when no one agrees with anyone. In these situations, which capture the two modes of recent market trading, current and the QE period, the markets become calm and volatility selling and carry strategies define the trading landscape. But, calm makes us worry, and persistent worrying causes fear, and fear tends to be reinforcing.

Persistence of low volatility causes misallocation of capital. This is how complacency leads to buildup of risk – it is the avalanche waiting to happen. For a given level of uncertainty, on the risk/reward curve investors settle at a point that corresponds to their risk limits. This position is determined by the volatility cone on the risk frontier, its width commensurate with volatility.

As volatility declines, the cone shrinks and returns decline. This compels investors to move across the frontier towards higher risk in order to enjoy the same return.

Endemic complacency, which continues to take hold of the markets, is likely to play an increasingly adverse role the longer markets continue to operate as they recently have. However, although volatility remains depressed, the risk continues to be pushed to the tails. This is a buildup of metastablity. The longer the stick remains still, the more surely it will fall.

In the past, (in rates market) we did not have to worry about this issue (until it became too late): Mortgages are negatively convex and that risk was transmitted from homeowners to capital markets through MBS hedging. As a consequence, rates market was negatively convex which maintained support for gamma and provided residual volatility. Mortgage convexity hedging practically disappeared after 2008 with convexity risk moving to the Fed’s balance sheet. The transmission mechanism between homeowners and capital markets was severed. This extinguished realized volatility and encouraged further volatility selling. Any attempt to own volatility was penalized by negative carry.

This change caused the major refunctioning of the rates derivatives market, from an extension of the MBS to an insurance market, and with this the action moved from at-the-money to out-of-the money. This was another blow to realized volatility (a 25bp decline of the mean, from 105bp to 80bp) which dragged down implieds as well.

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yogibear's picture

Central bank rigged market. Just look at the VIX, it's flatlining.

It's why it was smart to buy the ETF indexes.

xtremers9's picture

Where's the historical proof that this concept even works? For starters, (if you look at past bear markets), VIX always rises significantly before a bear market begins. So no, "a disaster is not just around the corner"

http://markethistory.org/why-a-low-vix-does-not-mean-the-sp-500-will-fall/

AllOfGood's picture

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Rabbi Chaim Cohen's picture

That link is not a great case for the uncharted waters we're currently in. All historical cases of VIX <10 were when the market was still an organic entity. Today, all bets are off in my book. You could be right, but would anyone be surprised if a crash began tomorrow? When everything is manipulated you'd need to be able to read minds (not interpret historical technical analysis)to predict the next big change.

Anarchyteez's picture

Uh your link doesn't argue against the authors premise.

gm_general's picture

I can't speak to some immediate crash, however the VIX since 2015 is trading between a well defined declining line of resistance (which hits around Brexit and days prior to the US election, and an also declining (slightly) line of support, which is currently in the 9s. Should there be some situation that causes the VIX to break over the line of resistance, and that is not hard as it is 17ish now, IMO all hell will break loose. A crash? Maybe, maybe not. But certainly a meaningful decline. You have to put cracks into it before you can break it.

Pretorian's picture

Deutsche when are you condutcting due dillgience on yourself and Germany?  Hugh Hendry once said Germans can not think out of box they never thought unscrew can go anti clockwise.

gold rubeberg's picture

"He also inverts the conventionally accepted paradigm that lack of volatility means lack of uncertainty ..."

Also contrary to popular opinion, lack of volatility sure doesn't mean lack of instability. A boulder balanced on the tip of a mountain peak may not be gyrating around, but it is dangerously unstable. At these levels stock prices are just as dangerously unstable. The instability derives not from lack of falling, but from having been pushed up so high to begin with.

SpanishGoop's picture

On DBs upcoming failure:

"It wasnt us, it was the "metastability which lead to this catalismic event".

Yeah, ok.

 

Dewey Cheatum and Howe's picture

theres 1 thing algo-ridden HFT traders must have, volatility. When there is none, trusty me...they will create some.

Anarchyteez's picture

Damn good point.

+

Hard to take out stop losses on a flat line.

AlexCharting's picture

DB, you should stop reading those philosophy books..... them words are too big for you :P

Francis Marx's picture

How many years now they hve been saying this stuff?

Unlikly a 25% equities correction any time soon. Dips yes..

Bond bubble...yes..

kochevnik's picture

That is the problem.  Inhibiting destructive processes almost assures historic crash.  IF is decided, WHEN is irrelevant.  Longer inhibition means greater crashing scale

ebworthen's picture

Misallocation of capital = Amazon, their "drone deliveries", and buying Whole Foods.

Seen any refrigerated UPS or FedEx trucks lately?  How "green" would that be?

A gallon of milk, a dozen eggs, and a loaf of bread by drone?  Oh sure.

Ban KKiller's picture

Red or blue pill? Hmmm....guessing this is DB's way of saying that their bank is almost tits up. 

BTW who trusts DB with anything, anything at all? Convicted liars...

IranContra's picture

Doom and gloom... are the banksters really in control of the world? Or is it their wishful thinking?

Meanwhile, the Left cannot take its eyes off of the mock-assassination of Trump. The real cataclysm that the Swamp (which has always been controlled by the Left) is worried about is the survival of Trump which heralds the return of Jesus Christ who will kill the Anti-Christ (which IS the Swamp). This is why the Swamp obsesses about killing Trump.

Nobody yearns stronger for the return of Jesus than Arab Muslims. He is their only hope of survival in their own homes which are being constantly attacked by the soldiers of the Anti-Christ (Iran, Muslim Brotherhood, ISIS, etc.) who all serve the Anti-Christ state (falsely called Islamic Republic/State). President Trump is seen as fulfillment of an old Muslim prophecy: a Roman military ally of Arabs against the Anti-Christ.

Why is Trump helping the Arabs? It's because the Anti-Christ's soldiers are in America, too, shooting wantonly at people they don't even know. The Swamp is the Anti-Christ, and it is spawning liberal ISIS soldiers, too.

It is good versus evil, globally. It's not about money.

GOSPLAN HERO's picture

Bitcoin ... no electricity, no Bitcoin.

Kat Daddy's picture

No electricity; STONE AGE!

kochevnik's picture

No electricity means no sun, which means nuclear winter or Yellowstone event

rjdsaldanha's picture
Deutsche Bank like a Bistable / Latch / Flip Flop that need a reset
Five Star's picture

The market is so stable because retail participation is at all time lows. Households now own less than half of all equities. All the buying is being done by ETf's, mutal funds, central banks, and large institutional investors who don't have the option of selling and sitting on the sidelines for wishy washy reasons like metastability. They are obligated to generate a return. They have pensions to pay out, debt to pay off, and budgets to balance.

http://thesoundingline.com/how-times-have-changed-who-owns-american-indu...

Five Star's picture

Actually it is true. Less than 50% of US corporate equities are owned directly by households, close to the lowest levet EVER, and the lowest percentage of households on record own stocks, about 52% of households.

http://www.gallup.com/poll/190883/half-americans-own-stocks-matching-rec...

The article you posted says that stocks represent an increasing percentage of hosuehold financial assets. But that is a completely different statement and does not meant that an increasing percentage of outstanding stocks are held by households, nor that an increasing number of households own stocks. It simply means that the value of stocks held by households with financial assets has risen relative to their other financial assets. That is a obvious fact if you have seen a chart of the DOW within the last 5 years.

 

 

veritas semper vinces's picture

I think DB is one of the best to make such comments,they are insiders and part of the problem.They should kniow.If they are honest,but this is another story

Horse Pizzle's picture

Deutsche Bank must cancel funding North Stream 2 else another $10 billion fine is coming their way.

Just Another Boob's picture

How much the system can be perturbed until the "metastable" goes over the hump is known as robustness.  Over time, the humps may disappear and the ball slides down the hill.  Anyone interested in the math for this should search on "Catastrophe Theory".  It was big in the early 1970's, preceding "Chaos Theory" by quite a few years.

But what does a boob know anyway?

vladiki's picture

The Fed's like a lion tamer. The market's the lions. No doubt about the power realities there. So far in the cage, the lions are quiet on their little stands. But they're staring intently at the tamer, and you can see them thinking, and the tamer's beginning to sweat, and I'll take a punt that quite soon, nature will have its way.

The Real Tony's picture

The people who own stocks will get eaten alive just like back in the old Roman days.

Boterkoek's picture

What do you mean, like in the old Roman days?

 

sevensixtwo's picture

>a catastrophic conflagration of epic proportions

Snaffew's picture

and all these words will end with the result being futures up and another strong green open for the US markets...the charade continues.  Only 10,000 more articles like this and then perhaps a 5 percent decline that will take the S&P down to 3k.  There are a lot of white towels being waved by the shorts, yet even that contrarian indicator will likely fail.

hola dos cola's picture

"Big changes threaten to explode not when uncertainty begins to rise, but when it is withdrawn."

If the economic data released last week becomes a trendsetter Q2 earnings will show Q1 to have been very good which validates the bearcase (long VIX to win the moment the market acknowledges the 'overvaluation' as priced in and sends the algos on a price discovery to where there won't be buyers.)

A  'scream' before is highly likely, says intuïtion.

 

PontifexMaximus's picture

Show me your book DB