Two weeks after Deutsche Bank’s whimsical, James Joycean derivatives strategist, Aleksandar Kocic disaggregated the market’s current sweeping complacency regime in a florid stream-of-consciousness report, and warning that the market's current "metastability" would lead to "cataclysmic events", with a crash becomes increasingly more likely the longer price discovery in the market (one not propped up by Federal Reserve) is delayed, in his latest note from this week he takes on a more practical - if just as abstract - target; quantifying complacency, both in a market sense and as a metaphysical concept (long-term readers of Kocic are all too aware that when it comes to fusing markets and philosophy, mostly of the post-modernist bent, nobody even comes close).
While we offer readers a TL/DR, Cliff Notes recap at the end of this post for those with little patience for parallels between existentialist, information overload and the decay of the VXX, we urge following Kocic’ narrative, if for no other reason than to comprehend to what abstract levels of market intellectualization the current phase of market “breakage” - courtesy of central banks of course – has prompted such otherwise dry commentary as cross-asset derivative analysis.
We start with Kocic’s definition of “complacency”, which the DB explains “carries a negative connotation -- there is something narcissistic about it. It implies unhealthy inward-looking perspective: One imagines of being in a better position than he really is, missing an opportunity to improve. When used in the market context complacency implies a state of comfort that is out of sync with perceived levels of risk. It is almost always identified with shortsightedness, a mistake associated with overlooking the long-term consequences. In the same way a boxer who drops his guard runs a risk of being knocked out, complacent markets are facing a potentially painful encounter with reality.”
With this brief detour into the fusion of trading and philosophy out of the way, Kocic then proceeds to do something nobody else has done before: quantify market complacency.
To do that, Kocic notes that at first one has to define the frame of reference of complacency. “Relative to what” should complacency – a conditional category that both reflects the absence of risk aversion and also is synonymous with taking on an unhealthy amount of risk – be quantified?
“In the same way risk aversion requires comparison of two independent measures of risk, complacency is defined relative to a perceived level of (unrealized) risk.”
As frequently happens in finance, Kocic uses a coin toss thought experiment to lay out the problem:
Consider a coin toss as an example. The physical probability between heads and tails is 50/50. However, any bets that involve coin toss as a decision instrument will always overweight probabilities of unfavorable outcomes. For example, if the payout of the gamble is $10 for the heads and $0 for the tails, no one would pay $5 (the expected value = 50% * $10 + 50%* $0) to play, but less than that, say $4. So, the actual price is evaluated as an expected value with 60/40 probability assignment (40%*$10 +60%*$0 = $4). This is the essence of risk aversion. Because the actual risk involved in a coin toss can be accurately determined, reweighting of probabilities which incorporate risk preferences can be measured precisely and quantified. The price of risk aversion is $1, the risk premium that is the difference between the expected price of $5 and the $4 at which it is traded.
Kocic then explains that he approaches the problem of quantifying complacency in the same way as we did for the risk premium in the coin toss example by comparing the two different measures of economic uncertainties: Economic policy uncertainty (EPU) index and VIX (implied S&P volatility).
Regular readers are familiar with the Economic Policy Uncertainty index which is constructed by counting the frequency of articles in ten leading US newspapers that contain three of the target terms: economy, uncertainty; and one or more of Congress, deficit, Federal Reserve, legislation, regulation or White House. These numbers are then properly normalized by their means and standard deviations of occurrence and combined into an aggregate index. As such, EPU is completely market independent (in the same way the mechanics of a coin toss is relative to any particular gamble).
And, as an alternative measure of risk, one that reflects the market prices, Kocic chooses the VIX, or simple equity volatility. The history of the two measures of uncertainty is shown in the Figure.
This is where things get interesting, because as the chart above shows, until 2012, for the most part both levels and spikes tend to be coordinated across two measures.
Intuitively, when VIX is in tune with EPU, the market is acknowledging the levels of risk through the prices. However, when VIX is low and EPU high, markets are complacent – they are underpricing risk. Spikes across different events are summarized in the Table (chronologically, from left to right).
While the two indices track each other well until 2011, that’s when something broke, or a Kocic puts it:
After 2011, the two measures of risk decouple with VIX consistently low despite growing uncertainty. The breakdown is structural, and it is visible across all market sectors, not only equities.
Having qualified complacency, the derivatives strategist then quantifies it:
In order to quantify market complacency, we compare the two measures in the following way. We regress EPU onto VIX until 2011 und treat the residuals as the measure of complacency. The two Figures show the EPU index overlaid with the regression scaled VIX and the residuals.
The visualization of the divergence between the VIX and the EPU, or what Kocic defines as “complacency”, is shown below:
This is where things get even more interesting, because by this measure, “it appears that the markets have made a structural shift towards higher levels of complacency in the last six years.” Here, Kocic reverts back to his old, cautious self, warning that this decoupling will end in tears. This is how he frames it:
Current levels of complacency are alarming. This is what everyone is talking about. Despite growing uncertainties and tensions, the market volatility refuses to rise. Persistence of low volatility is increasing the penalty for potential dissent and reinforces one sided positioning. As a consequence, the risk of disorderly unwind is growing. And the longer this regime continues, the lower the threshold of painful unwind. Currently, VIX at 15% is perceived as a problem although before the crises it had traded above 20% most of the time. Similar observations hold for rates gamma, currently around 60bp, compared to pre-crisis averages around 100bp.
Going back to our cleansing forest fire analogy (or rather lack thereof) we brought up last week, in which as Austrian economics posits it is imperative to burn the dry kindling in the forest periodically to avoid a conflagration, Kocic observes that sometime in 2012 the markets broke and it was as if “they lost their capacity to deal with uncertainty.”
But why? “Have the markets changed, or was it actual uncertainty that is different now? Is it our risk appetites or the “coin” that are different?”
At this point Kocic makes two key observations: one reason behind this decoupling between risk assets and uncertainty is that the market has been lulled into a quasi permanent sense of confidence thanks to central bankers, or as Kocic puts it, the “abnormalization of market volatility and turbocomplacency.” He explains:
The 2008 financial crisis represents a turning point in the way the markets have been pricing risk aversion, for the simple reason that during that episode the tail risk had been realized.
As a consequence, fear has gotten a new dimension. In the past, fear has always been treated as a sign of incompleteness, something one has to outgrow. After the crisis, fear has emerged as a new cognitive principle. And, as much as the Central Banks have tried (and succeeded) to reduce volatility, they did so by growing their balance sheet and, in that process, raised some red flags -- after all, it was the excessive leverage of the households and banks balance sheet that led to the financial crisis. The warning sign about the tail risk became louder, so much so that tail risk became a buzz word of the second decade.
While Central Banks reassured the markets of their intent to do whatever it takes to support risk assets, their balance sheet growth and risk of future unwind remained persistent topic in media. They were perceived as a source of (latent) systemic risk; everyone wanted to play in that space and the street was eager to source it. At the same time, backed by the Central Banks’, risk assets became positively convex and continue to gain in value as well as their stability. The post-2012 rise in EPU and divergence from the declining VIX was the result of these developments.
But it’s not just central bankers: according to the DB strategist, as time progressed, traders simply learned to start drowning out negative news, information and developments. Call it the market’s “fake news” development, or as Kocic puts it: “Semiotic inflation: Informational overload and disappearance through proliferation.”
When it comes to complacency, the reference point analogous to the coin toss is not exact and not known ex-ante; it is based on perception not on actual levels of risk. In this way, complacency is an implicit judgment about the quality of information that reports the danger.
When information becomes a commodity, it takes very little time for it to lose its value. Unlike other (physical) commodities whose price is driven by diminishing supply, information markets are exact opposite -- their essence is captured by diminishing demand. On one side, there is nothing to slow down its supply – it costs nothing to produce it. On the other, demand for information is biologically constrained by our capacity to absorb a limited amount of it. So, sooner or later, we have to reach a state of semiotic inflation where more information buys less meaning. The rate at which we reach this point depends only on the efficiency of the media. It is safe to say that in the last decade, especially the last five years, we have witnessed an accelerated approach to the state of super- fluid information flows.
This is when the positive feedback begins. When we operate under informational overload, we tend to defend ourselves by filtering excess information. It means that we are deliberately underplaying the importance of its content and implicitly questioning credibility of its sources. This can be perceived by those who observe us (our parents, guardians, parole officers, risk managers…) as troubling. And the more we ignore their warnings, the more they will be warning us. This is an example of disappearance due to proliferation: Filtering of the information forces its proliferation which is further ignored (we can’t absorb any more) and its production further reinforced until it is completely ignored and, therefore, invisible.
Think of the above as a thought experiment in which the boy repeatedly cries wolf, because he indeed sees a wolf, yet every time the wolf gets too close, central bankers “print” some ultrasound whistles and scare it away. Meanwhile, like in the story, any future warnings by the wolf boy are ignored even as the wolf gets hungrier and angrier, and one day nothing will be able to chase it away.
Which brings us to Kocic’s conclusion, which fuses his philosophical observations with what has become the most poignant chart of the new normal market – that showing the recent moves in the VXX and XIV::
“complacency and semiotic inflation have become two sides of the same coin. The abnormalization of market volatility is a function of both capitulation under informational overload and the moral hazard created by punitive costs of tail risk hedging in the carry trade environment. Nothing illustrates this better than the performance of the long (VXX) and short (XIV) VIX ETFs”
And, if Kocic is correct, nothing will better define the mean reversion of this abnormal market volatility regime than the explosion of volatility as a result of nearly a decade of pent up “abnormalization” and the traders’ realization that just because bad news was ignored since 2012, it never actually went away, but was simply swept under the carpet by panicking central bankers.
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Finally, as promised earlier, here is the Cliff Notes version of the above:
- Deutsche Bank has constructed a Complacency Index by comparing the existing Economic Policy Uncertainty Index with market implied volatility.
- According to that measure, the markets have undergone a structural shift to a new phase of heightened complacency after 2012 where the underlying uncertainty remains continuously ignored and underpriced.
- These effects become considerably more pronounced in the past 18 months with the complacency index rising by more than twice.
- Deutsche Bank believes that this is a function of both capitulation under the informational overload and the moral hazard created by punitive costs of tail risk hedging in the carry trade environment.
- This type of environment leads to misallocation of capital and buildup of one sided positioning and tail risk.