Picking up pennies in front of steamrollers. Volatility is an oft-used measure to gauge risk in financial markets. This week we explore a few facets of volatility; and we ask why, with so much uncertainty in the world, is volatility so low? Jawad Mian’s Stray Reflections this week explores the correlation between the VIX and the Global Risk Index.
# What is Volatility Telling US?
VIX vs Geopolitical Risk Index (rhs)...
# Is VIX is a poor measure of risk?
Despite rising geopolitical risks and lofty market valuations, the VIX Index has been recording new consecutive lows. In the past two decades the VIX has closed below 10 on only 11 occasions, and 7 of those occasions have been during the past month. Jawad rightly asks, ‘Are we going to see policy uncertainty decline and volatility stay lower for longer, or are we about to enter a higher volatility regime?’
# Volatility tourists?
JP Morgan’s Marko Kolanovic sees the death of the human investor as one of the key drivers of declining volatility. Only 10% of trading volume is currently derived from fundamental discretionary trades. Quant strategies and ETF algorithms are accounting for most of the trading, and their setup represses volatility. This happens because many of the quant strategies follow the same big-data and trend-following factor-based approaches. Volatility has been trending so low that yield-seeking ‘volatility tourists’ are joining in the party, seeing the low VIX readings as a chance to gain some yield in an apparently benign macro environment.
# Show me the volatility!
To put it another way, it is quite possible that the sheer weight of money currently flowing into short volatility positions, the implied central bank put, and the rise of passive investing and quantitative funds may be clipping potential volatility. Taking a different slant on our recent featured piece from 720 Global, these forces are making the graph on the left look more like the one on the right...
What that means is that the volatility of actual returns is increasingly resembling a random walk!
What’s the big deal about volatility?
Here we must cede to a master class from Chris Cole of Artemis Capital, whose ‘Volatility and the Allegory of the Prisoner’s Dilemma‘ is truly a piece of essential reading for any investor. If you want to get a handle on this crucial concept, you need to watch Chris’s Realvision TV interview. One of his key mantras is this:
“Risk cannot be destroyed; it can only be shifted through time and redistributed in form.”
Currently, suppressed volatility is merely storing up risk for the future, explosively; and the principal reason for this is that market participants believe central banks will be there to backstop any future random events that would otherwise cause significant stress in the market. Of course, this unwavering belief invites moral hazard and is driving the trade in shorting volatility. Central banks are in effect driving up the occurrence of apparently ‘everyday’ events and pushing out tail risk...
The key takeaway here for investors comes when Chris says, ‘Peace is not the absence of conflict.’ A simple way of thinking about this is that the active conflict between bulls and bears discovering prices in the market each day is for now being drowned out by the waterfall of cheap money pouring down from central banks. But the bulls and bears are still there, waiting.
# Here’s the bottom line;
When a risk event occurs that a central bank can’t or won’t step into, the volatility tourists are likely to be ruined, and the markets will be primed to for severe dislocations in pricing, something which the quants and algos aren’t programmed to navigate.
# Staying Ahead;
There isn’t time each week to discuss everything that is going on in markets. Here we piggyback on previous RVP Weekly Hack talking points and let you to explore some stories further.
*Who hit the bid? The SNB did.
If you need a sign of the times, check out the breakdown on the NASDAQ holdings of the Swiss National Bank. As the SNB fights to reinvest its vast foreign exchange reserves, it has become a large buyer of US tech stocks. In fact it now owns 3.75% of Apple and 3% of Amazon!
In the first quarter the SNB increased their holdings of US equities across the board by ~25%, hardly selective buying. It seems some central banks are in fact propping up the markets in quite a direct fashion. When we think about the meteoric growth of passive investing, we need to consider that ETFs may not be the only price-insensitive buyers, there are institutional ones, too.
*Tech companies make ripe pickings.
Are US regulators now looking to initiate trust-busting moves against the big tech companies? With the likes of Amazon and Google becoming increasingly dominant in their chosen fields, and choosing new fields every week, the motivation and incentives to increase regulation of these sectors is obvious.
There is a geopolitical angle here. In the period following the GFC, the US extracted a number of fines from European banks that needed to shore up their finances, whilst the EU engaged in various trust-busting activities against the likes of Facebook and Microsoft. Think of this as a kind of modern resource nationalism.
Are the US regulators about to turn on their own?