Submitted by Eric Peters, CIO of One River Asset Management
“When we can’t come up with a clear catalyst, that’s when we know whatever arises will (1) be unexpected, and (2) cause a greater reaction,” said the endowment. They were discussing what worried them, why they continued de-risking, exiting short volatility strategies, and adding long volatility.
“The inability to point to a catalyst means that the asset class (vol) is cheaper and becoming a better risk/reward opportunity than at other times. Since we have other strategies that win to the upside (equity, biotech, activism, etc) we’re happy to pick up vol when it’s cheapest (i.e. right now). It’s not that complicated.”
Interest rate and foreign-exchange implied volatility has plunged to levels that preceded the 1970s turbulence. Global stock market volatility is near historic lows as well. “I think the equity decline may be precipitated by an interest rate or foreign-exchange event causing a loss of confidence in equity markets.
Perhaps interest rates shifting higher/lower does it, or an EU crisis or something with the Japanese yen or Chinese renminbi.” Aggressive volatility selling persists, driven by investors who need to earn incremental returns, emboldened by the view that with all global central banks in a dovish mood there’s little risk of disruption.
“Vols are at all-time lows precisely because the risks are no longer top of mind. Wouldn’t surprise us if an issue in rates/FX happened first, causing equity weakness, followed by equity panic that crescendos to levels where the put options that people have sold really kick in. You would want to buy into that capitulation of course, because we’d get a quick 20% bounce (from down 40%),” they said.
“Don’t know about the direction of the second 20% after that rebound...would depend on what caused the rate/FX issue initially. The point is, everyone is focused on equity risk, but paying no attention to rates/FX, which means that’s probably where the next issue will arise.”
“The 737 Max 8 can be flown safely without these two gauges,” said the pilot union spokesman, “But there’s a broader margin of safety if you’ve got them.” Boeing charges a little extra for a safety feature that alerts pilots to faulty information from key sensors. Boeing’s CEO weighed the risk/reward, then chose to charge customers for something that should obviously come as standard on every $120mm passenger plane.
The CEOs of Ethiopia and Lion Air also weighed the risk/reward, then chose to not buy that optional safety feature. And as we all marvel at those catastrophic miscalculations, the cost of protecting our investment portfolios using volatility is at or near the lowest levels since the 1960s.
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- “The extremely accommodative low interest rates we needed when the economy was quite weak, we don’t need anymore. We may go past neutral, but we’re a long way from neutral at this point, probably,” said Fed Chairman Powell (Oct 3rd), weighing the risk/reward of policy action/reaction. With interest rates ‘a long way from neutral’, investors hammered stocks. The S&P 500 fell 8% in Oct.
- “Interest rates remain just below the broad range of estimates of the level that would be neutral for the economy,” said Powell (Nov 28th). Hearing the dovish shift to ‘just below’ neutral, investors raced to buy the S&P 500. Four days later it puked, for no real reason.
- “We thought carefully about how to normalize policy and came to the view that we would effectively have the balance sheet run-off on automatic pilot,” said Powell (Dec 19th), with stocks already in free-fall. The S&P ended Dec -9%.
- “We will be prepared to adjust policy quickly and to use all our tools to support the economy should that be appropriate to keep the expansion on track,” said Powell (Jan 4th), and stocks embarked on an explosive rally.
- “This is a good time to be patient and watch and wait and see how the economy evolves,” said Powell (Feb 26th), after a 19% rise from the Dec 26th panic low. Investors loved what they heard, but stocks barely rallied.
- “I don’t feel we have kind of convincingly achieved our 2% inflation mandate in a symmetric way,” said Powell (this Wednesday), indicating the Fed is willing to risk economic overheating, rising inflation. Bulls lifted stocks to new 5mth highs.
But by Friday, the S&P 500 reversed sharply to close the week lower, for no particularly good reason, but for the fact that after a 22% bear market rally, buying stocks because the Fed has completed a 5mth policy U-turn is seriously bad risk/reward.
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“The Fed just told us they’re not screwing this market,” said Bulldog, drool dripping. “Stocks are supposed to grind up now, there’s no doubt about that, everyone knows it,” said Dawg. “So that’s what’s probably going to happen.” And he sat down with a thud, for a quick lick. “But you gotta watch markets like this, where everyone pretty much knows what’s going to happen, because when they don’t go the way they’re supposed to, it gets real ugly real fast. So whatever direction markets head from here, go with it,” he said, and went back for another lick.
“The long bond yield has gotten me agitated,” continued Bulldog, returning to all fours, clean, refreshed, ready. “30yr yields don’t lie, and when they break down like they just did, it means something’s not right.” US 30yr bond yields fell to a 14mth 2.88% low on Friday, well below their 3.45% Nov 2nd high. “Maybe the Europeans and Japanese figure they’d rather buy US bonds and take the FX risk instead of earning nothing for owning their own 10yr bonds.” 10yr German bonds yield -0.02%, Japan -0.08%. “But something smells wrong."
Wag the Dog
“Retail sales collapsed in Dec by the most since 2009,” said the investor. “No one has offered a compelling explanation.” Consensus estimates ranged from a +1.1% monthly rise to a -0.2% decline – in fact, retail sales plunged -1.1%. “One hypothesis is the US now has an insane wealth function. If that’s the case…Jesus.” At the Dec lows, the S&P 500 was -15% on the month. People usually think the economy drives the market, but what if that relationship has reversed? “It wasn’t a Lehman moment, but in terms of the retail sales reaction, it was close.”
“There’s an extraordinary amount of vol selling,” said the PM. “When you sell vol, you win 80%-90% of the time, so people try to increase the number of observations.” Traders now sell intra-day volatility on stocks. “When you increase your observations like this, you’re implicitly spiking your gamma -- I wouldn’t want that kind of exposure in October 1987,” he said. “But banks that provide this exposure take the other side of the short gamma trade, and as they hedge that exposure, they crush market volatility. And this will continue until it doesn’t.”
"Markets always produce liquidation events," continued the same PM. “Markets need to flush positions periodically,” he said. "Investors have observed that for years, selling volatility has been superior to being outright long stocks.” So they now exchange their stock portfolios for volatility-selling programs. “Despite the fact that implied volatility has moved lower, realized vol has declined too - that spread is the source of steady profits. So vol selling has continued to look attractive even as vol has declined. And this too will continue until it doesn’t."