2017 has been the year to sell volatility. Volatility on nearly all asset classes has been compressed to historically low levels, which is a function of the world’s major Central Banks going into asset purchase overdrive for the past 18 months. When you flood the global financial system with free money, people tend to leverage up the carry trade and buy anything with yield.
Central Banks in full-out crisis mode to keep prices elevated and yields/volatility compressed
The issue with this from the perspective of portfolio construction is that correlations between just about all asset classes increase. This means you’re not as diversified as you might think. 2017, in a way, has also been the reverse of 2008. Remember 2008? 2008 was a disaster for those not prepared because everything but treasury bonds and the US dollar went down. Everything was correlated in a bad way. There was nowhere to hide and the flaws of standard portfolio diversification models were exposed. The reason has to do with volatility and convexity.
Most investors are “long only” investors, meaning that they buy/own investments and they make money by collecting income or if the value rises (your traditional way of investing). The flip side of this is to “sell short” an investment which makes money if it goes down. Now, I’m not proposing that people go out start shorting investments because that’s a very tricky game to play. The important concept here though is that when you own an investment you are effectively “short volatility” against that investment. Volatility tends to be inversely correlated with price in the investment world. When prices fall they tend to fall quickly so volatility spikes. So if your entire portfolio is full of “long” investments (i.e. you own stocks, you own bonds, you own real estate, you own etc…) then your entire portfolio is short volatility and benefits during periods of time when volatility is falling/compressed. Like in 2017.
I bring this up because the amount of money betting that volatility will continue to fall, continues to rise. This has many, myself included, a little worried about the effects of an unwind. This is very similar in nature to the “portfolio insurance” concept that caused Black Monday in October, 1987 when the stock market fell 20% in a day! When too many people pile onto one side of the boat, the unwind can be vicious. I don’t expect a drop like that to happen in a single day but I do think we’ll continue to see very sharp pullbacks based on the reflexive nature of today’s market constructs, followed by further periods of volatility compression and almost no movement.
Total VIX Futures Positioning
(h/t Jesse Felder)
And on top of this, margin balances continue to grow. So not only are people betting on continually falling volatility/rising asset prices, they’re doing so with ever more leverage.
Total Margin Debt for US Stock accounts
This is where hedges come into play. You can hedge your investment portfolio by owning things that rise in value when volatility spikes to help offset drops in your core portfolio holdings. A perfect example is to own a put option on a stock or the stock market in general. A long put option is long volatility and exhibits positive convexity. Convexity is one of the most important, yet least understood investment concepts. Convexity is when the change in value of an investment holding is not linear on a one-to-one basis to the change in an underlying base; it’s curve-linear. The gains (losses) will accelerate and pick up steam the further it goes in your favor (against you). In option terminology, we’re referring to gamma. It’s kinda of like duration with bonds but instead of being constant, it’s as if the duration increases the more interest rates rise, compounding the pain.
I’ve discussed some investments in the past that have a long volatility component attached, or at least is non-correlated with assets that are short volatility (e.g. stocks). See here and here.
The best investors/traders will look for things that exhibit convexity and asymmetric payoff profiles. What can you buy that risks very little but has a huge potential payoff?
One of the best papers I’ve read on these topics is called Volatility and the Prisoner’s Dilemma. It was written 2 years ago by Chris Cole of Artemis Capital. With Janet Yellen laying out the Fed’s framework for reducing their balance sheet last week, I pulled it out and reread the piece. Everything discussed in it is even more relevant today than it was 2 years ago because the issues have compounded. I highly recommend it if you want a better understanding of some of the underlying fragilities in today’s global investment markets.
I learned a long time ago that things in the markets are rarely as they appear. As I discussed above, I don’t think people realize some of the underlying stresses that are building in the markets because all they tend to hear from the mainstream media is that the stock market continues to grind to new highs. Therefore, everything must be fine. A few weeks ago I wrote a post about looking at the internals of the stock market to judge the breadth and strength of a rally. Here’s another chart to illustrate what I mean when I say that all is not what it seems. Markets tend to exhibit similar patterns and cycles again and again. One has to do with the breadth and momentum of a rally. Here is a chart showing the S&P 500 Index relative to the number of constituents trading above their 200 day moving average. Rotation and continued outperformance by the largest companies is keeping the index as a whole elevated but clearly there are fewer and fewer stocks participating in the rally.
Here’s the same chart going back 5 years. Even though the rally looks and feels like it did during the heydays of QE in 2013/2014, we can see a serious divergence in the breadth of this rally which makes me believe we have a pullback coming. With the debt ceiling recently extended 90 days, certain funding constraints have been pushed off until Q1 2018 so I’m not expecting a major top here but the point is that the US stock market is not as strong right now as it may seem and the short volatility build-up could make for a nasty dip.
Managing risk in an investment portfolio is a little like doomsday prepping. You need to constantly assess anything that could go wrong and how bad it could be. Odds are most bad scenarios won’t ever materialize but you’ll sure be glad you were ready for it if one does. How much of your portfolio is short volatility and exposed to negative convexity?
Thanks for following!
-Nick