Low Volatility Risk in the Market and New BIS Warning
by Victor Sperandeo with the Curmudgeon
We tend to think in terms of equities when we hear that "low volatility breeds complacency risk."† But there is a great deal more to the specifics and details than to assume low volatility is bullish (or bearish).† Surprisingly, the concept of "volatility" is discussed and used improperly by many investment professionals, market analysts and retail "investors."
Standard Deviation and its Application to S&P 500 and Platinum:
Volatility is usually measured by the statistical term "Standard Deviation (SD)," which is the square root of the variance (average of the squared differences from the arithmetic mean value).† For a finite set of numbers, the standard deviation is found by taking the square root of the squared differences of the values from their average value.
For example, the Standard Deviation of the SPDR S&P 500 ETF (SPY), measured over a one year time period, is currently 11.57.† If the S&P had gained 1% each and every month over the past 36 months it would have a standard deviation of zero, because itís monthly returns didn't change from one month to the next.† Conversely, if the S&P lost 1% each and every month over that same 36 month period, it would also have a standard deviation of zero. That's because its returns didn't vary.
In other words, if the returns don't vary much (over whatever time interval you chose), SD is quite misleading of what the market risk actually is.
Let's examine the recent price behavior of the commodity platinum as an example.† In the last 20 trading days, it has declined from $1425 to $1300 or (-8.8%), with a SD of only 6.95%. The low SD daily decline has been slow, but very consistent and constant.† Is that a good thing?† Not if you're long platinum!
Implications of low SD in U.S. Equities:
We maintain that low SD in equities, which are moving up for an extended period of time, strongly increases risk potential.† In fact, it might culminate in a future crash.†
That's NOT what the Fed has put forth in its mantra, which presumes that there is no risk in owning stocks.† Why?† Because ZIRP and QE benefit assets like stocks, bonds, and real estate.
To EVEN hint that the last 5.75 years of the Fed's reckless monetary policy has not distorted investments is an extremely naive view.† See the BIS report quotes later in this article for proof.
The low volatility and continued up move in equities (courtesy of the Fed) has led most market participants and "investors" to see financial assets as an "ATM -like, golden goose investment."† That misguided notion has produced incredible complacency in the market for a very long period of time.† Please see my Closing Comments and Conclusions below for how it might end (timing uncertain).
Another BIS Warning:
The latest Bank for International Settlements (BIS) quarterly report, published Sept 14, 2014, is titled: Volatility stirs, markets unshaken.†
It's yet another warning from the BIS to its member banks.† Central banks (especially the Fed) didn't listen to the last warning just a few months ago to raise short term interest rates sooner than they planned to do so.
Here are a few selected quotes (bold font added by the Curmudgeon for emphasis) which one wouldn't normally expect from the bank for central banks:
"The exceptionally accommodative monetary policy of recent years is also likely to have played a key role in driving volatility to such exceptional lows. Policy has had a direct effect, by compressing volatility in fixed income markets. For example, the reduction of interest rates to the effective lower bound in all major currency areas has pinched down the amplitude of interest rate movements at the short end of the yield curve. More transparent central bank communication, forward guidance and asset purchases have also removed uncertainty about interest rate changes for medium and longer-term maturities.
By fostering the search for yield and influencing risk appetite in the market, accommodative policies have also had an indirect effect on volatility. An environment of low yields on high-quality benchmark bonds - coupled with investor confidence in the continuation of favorable market conditions - is set to foster risk-taking behavior. This then tends to be reflected in lower hedging costs via options, as well as a general narrowing of risk premiums. In fact, the decline in volatility across asset classes since mid-2012 has gone hand in hand with rising asset valuations and collateral values more generally. As the capital constraints faced by financial intermediaries are alleviated, these institutions have an incentive to take on more risk, sending asset prices higher. This potentially creates additional feedback effects, since return volatility tends to be dampened when valuations rise.
As market participants further revise down their perceptions of (market) risk, they may be inclined to take larger positions in risky assets, boosting prices and pushing volatility even lower.
There are also signs that investor confidence in the continuation of low volatility and ample funding at low rates has encouraged market participants to take increasingly speculative positions on volatility in derivatives markets. The popularity of such leverage-like investment strategies can be gauged from open interest in exchange-traded volatility derivatives. CFTC positioning data indicate further that speculative (non-commercial) traders have significant overall net short positions in VIX futures, a sign of their continued willingness to sell insurance to other investors against rising volatility, despite a fairly narrow volatility risk premium."
Note:† We strongly suggest readers check at least two sets of charts in the referenced BIS report.† They illustrate Asset Prices Reflect Shifting Macro Risks and Low Volatility Everywhere (exceptionally low volatility for many different financial assets).†
Investors Ignore Risks in Cross-Asset Volatility:
In the Sept 16, 2014 edition of Sixth Man Research titled "The Nautilus Shell,Ē Mark Lapolla and James O Patterson wrote:
"Although investors generally appreciate the inverse relationship between volatility and the price of risk with asset classes, they are unconcerned or unaware of the risks associate with cross-asset volatility."
.... (later in the article)... "As in every previous economic cycle, (corporate) profits as measured by BEA National Income and Product Accounts†† have rolled over well before S&P 500 earnings per share (EPS) did the same.† Head winds (for U.S. equities) are intensifying from Obama-care, decelerating stock repurchases, and broadening technical divergences."
The authors state that the high yield bond market is struggling under the weight of a heavy offering calendar.† Could a waning risk appetite be also to blame?† Let's look take a closer look.
In a recent article titled Junk-Bond Investors Start to See Warning Signs Mike Cherney of the Wall Street Journal asks: "How long will the conditions persist that gave rise to a five-year rally in junk bonds and other risky assets?"
Analysts say there are warning signs which suggests "investors" should be more careful about the bonds (or high yield funds) they buy.† Companies with more leverage and low ratings could be at a higher risk of default if the junk bond market cools off and long term rates rise faster than expected.† If so, could that be an early warning signal for equities?
Don't Believe U.S. Government Forecasts:
The rosy U.S. government statements seem too good to be true.† For example, the U.S. economy has been in a recovery since June 2009 - or 63 months. The CBO predicts no recessions for the next 10 years!† That's 120 more months for a grand total of 183 months without a recession.
Isn't that a wonderful forecast?† Yet it ignores that the longest economic recovery since the National Bureau of Economic Research (NBER) started measuring those recoveries (from 1857) is 120 months (March 1991-March 2001). Thereby, the CBO suggest that the record U.S. recovery for 157 years (from 1857) is to be broken by +52.5%?† Compare the CBO forecast with the average recovery post WWII which is only 58 months!†
Is there some disconnect here or has the U.S. entered a "new era" of never ending economic growth?
The logical deduction of low SD, and low "volume" at, or near, all time stock market highs is certainly a high risk environment, especially considering where we are in the economic recovery cycle.†
Which Stock Market is in a Bull Trend?
It should be noted that several stock market averages are down for the year, e.g. Russell 2000 (-3.81%) Value Line† (-1.20%), while the Dow Industrial average is up only +3.24% and the NYSE Composite +3.83% after nine months of 2014. A small downdraft will end the year in the red for those averages.
Closing Comment & Conclusions:
In the commodity world, high SD is equally bullish or bearish, while in the stock world high volatility occurs almost 95% when itís in a bearish trend.
In conclusion, markets are made up of humans and they are fallible.† In my first book "Trader Vic -Methods of..." I refer the reader to an excerpt from chapter 4† "Finding Order in Market Chaos: An Introduction to Dow Theory."
"The nature of a market simply allows participants to adjust and correct their errors rapidly (and together). Any method of analysis that claims the markets are infallible is flawed at its roots."†
Therefore, I believe the market up move will have to be unwound very fast.† That's because the Fed's "manipulation" has caused too many "investors" to be long stocks in the false belief that there is a "free lunch."† The exits will be very crowded when all those longs want to sell stock at the same time.
Hence, the idea that the Fed is protecting your investments ("the Greenspan/Bernanke/Yellen put") is absolutely incorrect, even though it has worked amazingly well ---so far!
Todayís very low volatility and very low volume stock market environment is like Evel Knievel motorcycle jumping.... It's a very dangerous way for "investors" to make a living!†
Till next time......
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.† Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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