When Wall Street's fear gauge, the Vix index (.VIX), shot up 116 per cent in one day in early February, the S&P 500 (.SPX) duly fell 4.1 per cent. It has since recovered, as it did after similar rollercoaster rides in the first half of this decade — except for one difference.
Such volatility then did not cause so much fear. Defined as a measure of dispersion of returns of a given security (or index) around their long run average, it provided an ideal opportunity for exploiting temporary price dislocations, according to 71 per cent of investors in a survey published at the time.
The backdrop was mostly benign then. Quantitative easing by the key central banks had effectively put a floor under asset values, after driving investors up the risk curve. With the exception of the eurozone, many economies were gradually healing after the devastating crisis in 2008.
Indeed, a certain degree of volatility — about 10 per cent — was viewed as healthy for markets to revert to their fair value, after periodic ups and downs.
That sentiment is likely to have changed after the February debacle, when the sudden collapse of three small exchange-traded notes — solely designed to profit from volatility — sparked a worldwide market contagion at a time when the global economy was hitting fresh highs.
Outwardly, markets may appear calm but fragility is now building under the surface, as central banks gradually take away essential crutches by ending the era of super easy money. Only 12 per cent of the respondents in our latest survey believe that this will not happen in this decade. The rest think that they will have to learn to stand on their own two feet — once again. Caution is the new watchword. Volatility can be a friend if, for some reason, markets overreact, fall steeply and throw up unexpected bargains. However, whether markets have indeed overreacted or have simply absorbed new information only becomes clear in hindsight. The higher the volatility, the harder it is for investors to tell the difference.
Buy-the-dips only makes sense if accompanied by the corresponding sell-the-peaks that takes some money off the table from time to time. Most mainstream investors are not geared up to make such tactical calls; nor, for that matter, catch a bubble before it bursts.
If anything, the changing market structure has made it harder for investors to distinguish "noise" from "signal" whenever markets tumble. The increased presence of programmatic investors — covering managed-volatility funds, risk parity funds and trend-following funds — often exaggerates the directional velocity of markets, irrespective of fundamentals. Only fleet-of-foot professional traders can take advantage of that.
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In the institutional space, the problem is compounded by peer risk and career risk that often take precedence over investment risk. The trustee boards prefer to stay within the pack with no outliers. As John Maynard Keynes observed, "worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally".
In addition, as ageing demographics drive ever more pension plans into the payout phase, volatility poses two significant risks. The first one is the sequence of returns risk — the time taken for a portfolio to recover after a big market fall. The bigger the fall, the longer the period. The second risk is the asymmetric nature of asset class correlation: low in a rising market and high in a falling market, ensuring that diversification fails when it is needed most.
Equity-implied volatility reached a new all time low in 2017. However, the latest data on the future direction of the Vix index from Bank of America Merrill Lynch argue for caution. They indicate fears lurking in the background.
First, the cyclically adjusted price/earnings ratio for the US market is now above 30: the only other times it reached this high were in 1929 and 2000, both being followed by market reversals. Worries are building, as the current bull market gets within spitting distance of being the longest in history.
Second, geopolitical risks have risen due the growing spectre of trade wars between major nations and the continuing rise of populism in Europe after the latest Italian election. This is all too evident from last week's market turbulence in the wake of the Italian crisis.
Third, many emerging economies are once again vulnerable to further rate rises in the US. They lack a credible growth or reform narrative — for now.
While the likelihood of any of these events is hard to predict, the tendency to mistake every volatility spike for the start of the next bear market remains evident. As greed gives way to fear, what was once a friend has turned into a foe. The longer the correction is delayed, the longer the reversal will take.
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