In an interview with Bloomberg Tuesday, University of Chicago economics professor Richard Thaler went on to say in response to the market’s low volatility and continued investor optimism, “It’s certainly puzzling… and it’s puzzles that attract my attention.” He added that he is nervous, and when investors get nervous “they are prone to being spooked.”
A World Without Risk?
These observations and, specifically, the quote I started with this morning are much like what I have been saying in my Diary — namely, that never in history have there been so many potentially adverse political, geopolitical, economic and market outcomes.
I am not alone in this view, as Macquarie’s Viktor Shvetz recently wrote:
“Investors are probably suffering extreme mental exhaustion. Historically low volatilities and risks, coinciding with high valuations, would make anyone nervous.”
According to the brokerage, the reason for this underlying dysphoria is that “investors understand that there is nothing normal in the current environment of unprecedented financialization and economic disruption. The deadweight of US$400 trillion ‘cloud’ of financial instruments (backing into assets that are either worthless or are declining in value) must be supported by ongoing financialization.”
In a world seemingly without risk and with spreads at all-time tights, Bank of America’s David Woo writes in a similar vein that the market is more complacent than it was in the summer of 2007:
“This implies that liquidity must continue to grow, volatilities must be controlled and neither demand nor supply can yield higher cost of capital. Thus, risks facing investors are that either CBs and/or China misjudge extent to which reflation is dependent on inflating asset values and China’s fixed investment.
If the market is underpricing the uncertainty with respect to the outlook of US monetary policy, we are even more concerned that it seems totally impervious to the risk of two potentially disruptive, if not dangerous, Games of Chicken likely to unfold in the summer and the beginning of the fall….
“We find it difficult to reconcile the record low volatility in financial markets at the moment with growing political risk in Washington and geopolitical risk in Asia. There are many reasons why we are living in a different world than the one we used to know and we would caution against relying too much on history for forecasting the likely outcome of these risks.”
Yesterday I observed the volatility records being made recently:
“Month to date, the annualized realized volatility of the S&P Index is 5.2% — that’s the lowest vol in an October in over 90 years.
By means of perspective, the average October volatility since it has been recorded is 17.0%.
It is interesting that the four other low volatility Octobers all occurred in the 1960s — a period that preceded a sharp acceleration in inflation and rise in interest rates over the next decade.”
So, with volatility at record lows, the S&P 500 climbing to new heights and the Nasdaq higher in 10 of the 11 trading sessions, why do I think the risks associated with a “flash crash” are multiplying?
It is market positioning — something I and others rarely consider in our market analysis.
Today, speculators have breathtakingly large short positions in volatility futures, so that a relatively small spike lower in the averages, for any reason, of 3% or so could drive volatility much higher and demand (covering) of VIX futures. (The largest S&P selloff when the VIX was under 12 was 3.5% in February 2007).
Let me explain how a short volatility unwind might develop and what its implications are.
If Markets Spike Lower and the VIX Goes Bananas
It is tautological that as volatility moves lower and stock prices move higher, risks rise.
Several buy- and sell-side analysts have done a great deal of work as to what current positioning in the market may have if an exogenous event (from any Black or “Orange” Swan) produces a quick woosh lower in the averages and a spike in volatility.
From Morgan Stanley’s Chris Metli:
“It’s easy to become numb to the low volatility environment and the risks it presents. While trying to pick a trough in vol has been a fool’s errand, focusing on the risks resulting from vol being so low is not. Low volatility has produced a regime where the risks are asymmetric and negatively convex, so being prepared for an unwind is critical. This is not a call that vol is almost to spike, but you need a plan if it does.”
The pain of an unwind in VIX futures could be exacerbated in the days following a woosh lower by the dominance of passive investors (quant strategies and ETFs). The deleveraging of highly leveraged risk-parity funds, in particular, represents a risk that may not be easily repaired or reversed after the initial market drop.
Here is a further explanation from Morgan Stanley by way of Zero Hedge of the positioning risks that were in place in July.
Since then, as volatility has declined and the S&P index continued to climb, the risks have grown greater with an even larger base of short volatility futures.
Francesco Filia of Fasanara Capital writes about the potential damage delivered by the possible covering of short volatility futures:
“Market fragility must surely be a concern in the current investing environment. Yet, the psychological damage on investors and their behavioral reaction function to a sudden risk-off environment can never be as certain and direct as a wipe-out risk to a whole cluster of them. That is the nature of the risk that short-vol vehicles are facing today.”
And consider this important update on positioning from Morgan Stanley’s Metli — specifically, that more than 400,000 VIX futures would likely needed to be bought if the S&P Index falls by 5% in one day, nearly double what it was in July!
Though large daily drops in the markets are rare, the factors that could contribute to a quick drop have increased.
Investors have been concerned about the VIX for years, but the positioning has now moved to an extreme. Such positioning could accelerate a market drop as the chances of a flash crash have escalated.
But, Dr. Minsky has warned about the risks of becoming numb to the risks associated with a period of stability amid rising asset prices; it is not only inevitably followed by instability, it inevitably creates it.
In a world in which the chances of an external market shock are rising and at a time when volatility is cratering and stock prices never decline, the risks of a flash crash caused by the one-sided market positioning in VIX futures is increasing and are at a higher probability of occurring than at any time in history.