Some weekend observations on volatility and risk, excerpted from the latest batch of Weekend Notes by One River CIO Eric Peters.
* * *
“Things had been too easy for too long,” said Roadrunner, the equity market’s biggest volatility trader.
“Yet vol has found a bid on each dip for weeks,” he said. “The market saw this coming.” The S&P 500 rallied +7.5% in the first 18 trading days of 2018. Yet implied volatility levels rose. Then stocks fell -3.9% in 5 days.
“When stocks dump on a Friday, closing at the lows, and you haven’t hedged, it makes for a long weekend,” said Roadrunner. “People are worried that higher interest rates kill this bull market. I’m more worried about lower interest rates,” he whispered, darting looks left, right, up.
“Stocks should trade down hard Monday morning.” As hedgers sell. “Then we get to see where this thing really wants to go.”
“If we believe something, does that make it true?” he thought, unsure. When asked if the US government is concealing what they know about the 9/11 attacks, 49.6% of Americans agree or strongly agree. Is the government concealing what they know of JFK’s assassination? 49.6% agree or strongly agree. Alien encounters? 42.6%. Global warming? 42.1%. Plans for a One-World government? 32.9%. Obama’s birth certificate? 30.2%. Origin of the AIDS virus? 30.1%. Supreme court justice Scalia’s death? 27.8%. Apollo moon landing? 24.2%. Hmmm.
It raced across the night sky at 150,000 mph. No larger than a marble. The meteorite vanished in a trail of brilliant light, a faint green copper glow, come and gone. And his heart raced, recalling that first shooting star, decades ago, a child in a backseat, face pressed to the window, searching the heavens. His excitement late that night, replaced by profound sadness. The tragic fate of that distant star, its surrounding planets, its children too, all gone in a magnificent flash. The enormity of that tragedy consumed the little boy. But the more he thought about it, the less it made sense. So he found an encyclopedia.
And having set the record straight he returned to a world filled with Easter bunnies, Tooth Fairies and Santa Claus -- all such wonderful things, as real as the sky is blue, just so long as he never stopped to consider their impossibility.
In time, as he explored the history of humanity, he marveled at our ability to believe anything, everything. Religious and political leaders have us believe in things we fear. Business leaders have us believe in things we covet. Scientific pioneers challenge our beliefs. But left to our own devices, we simply believe in those things we most want to believe. Miracles and magic. Holy Grails. Buried treasure and Bitcoin. The lottery. Alchemy. We want to believe so badly that these things become real, for a time.
The history of markets is a tale of such things, our myths, manias. Illusions, delusions. As they unfold, they’re as real as Santa.
Today we’ve come to believe that volatility is the same thing as risk. When volatility declines, large risks become small. Which allows us to take more. And because volatility is mean-reverting, there are no risks provided we never exit a position. But the more he thought about it, the less sense it made.