Is Volatility a Ticking Time Bomb?

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It’s amazing how fast this year has flown by. It’s already (Mo)November! Unfortunately, the only way I can donate to the cause of the Movember Foundation is through monetary means, not through a beautiful Tom Selleck mustache. In fact, there probably isn’t a reason big enough for me to grow a mustache if I’m being considerate of all those that see me on a daily basis. Let’s just say facial hair growth isn’t my strong suit. But, I digress…

Some Stats

“Zombie” Companies



One of the most lucrative trades of the year has been shorting volatility. As an investor sees a spike in volatility they short it. They do this over and over again. Shorting volatility and deriving short incremental gains. It’s a bet or assumption that the markets will stay stable, but in exchange, the investor is also taking on the risk of substantial loss if events change and volatility increases. Artemis states, “Lower volatility begets lower volatility, rewarding strategies that systematically bet on market stability so they can make even bigger bets on that stability.” So, why should we care about this trade? “The Global Short Volatility trade now represents an estimated $2 trillion in financial engineering strategies that simultaneously exert influence over, and are influenced by, stock market volatility.” Artemis goes on to say…”We broadly define the short volatility trade as any financial strategy that relies on the assumption of market stability to generate returns, while using volatility itself as an input for risk-taking…The danger is that the multi-trillion dollar short volatility trade, in all its forms, will contribute to a violent feedback loop of higher volatility resulting in a hyper-crash.” When you chart volatility you realize that it has nowhere to go but up. Currently, there’s no catalyst to produce that upward move due to easy credit conditions, low rates, and excess supply of capital to invest in assets around the world. But, don’t get too comfortable because central banks are massively reducing their money printing efforts.

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Arguably the only undervalued asset class in the world is volatility. The short volatility trade is another way to provide yield to yield-starved investors outside of the fixed income world. It’s becoming an alternative to fixed income. Global money printing has created this very weird but interesting scenario, and there is a very specific occurrence that’s keeping this trade from collapsing in recent years. Since 2009, US companies have spent $3.9 trillion on share buybacks, which could be considered a massive levered short volatility position. According to the Artemis whitepaper, “In 2015 and 2016 companies spent more than their entire annual operating earnings on share buybacks and dividends.” Artemis goes on to say…”Absent this accounting trick (buybacks) the S&P 500 would already be in an earnings recession. Share buybacks have accounted for +40% of the total earning-per-share growth since 2009, and an astounding +72% of the earnings growth since 2012. Without share buybacks earnings-per-share would have grown just +7% since 2012, compared to +24%. Since 2009, an estimated +30% of the stock market gains are attributable to share buybacks.” These share buybacks are a huge contributor to our low volatility environment because large price-insensitive buyers (the companies themselves) are always ready to purchase on market weakness. Artemis goes on to say…”Share buybacks result in lower volatility, lower liquidity, which in turn incentivizes more share buybacks, further incentivizing passive and systematic strategies that are short volatility in all their forms.” This is all thanks to global money printing, which artificially depressed interest rates, which in turn allowed these companies to borrow money at historically low rates, which gave them the liquidity to buyback shares of their stock. It’s an optical illusion of growth.

Back in the day, the only investors that had access to this volatility trade were hedge funds or a wall street firm trading desks. Now your grandma and grandpa can trade volatility with the overabundance of newly issued ETF’s some being leveraged products. The majority is on one side of the volatility trade. What happens when the wind changes direction and volatility ramps up? Let’s just say there will be a very large liquidity gap for those trapped in short positions. These leveraged Volatility products will have unmeasurable losses and many will be completely wiped out. Artemis believes at current risk levels, as much as $600 billion in selling pressure would emerge if the market declined just 10% with higher volatility.

Over the years there has been a massive shift from active management to passive management. It’s easy to see why as passive management provides lower fees while building a diversified portfolio. According to Bernstein Research, 50 percent of assets under management in the US will be passively managed. According to JP Morgan $2 trillion in assets have moved from active to passive strategies. Here’s the problem, this huge move from active to passive will amplify future volatility. Think of it this way…active managers provide somewhat of a buffer to volatility. They step in and buy undervalued stocks when the market is falling and sell overvalued stocks when the market is rising too much. Now, remove that buffer. What do we have? We have a very small amount of incremental sellers when stocks become overvalued and we have a very small amount of incremental buyers to stop a crash on the way down. This creates liquidity gaps because that active management buffer is no longer available. I’m certainly not saying that passive management is a bad thing, but we are seeing some unintended negative consequences of this massive shift in investor mentality, which could produce higher future volatility.

Volatility won’t be the thing that starts the fire, it could be the thing that pours fuel on the fire. Artemis states, “Volatility is the brother of credit and volatility regime shifts are driven by the credit cycle. When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity lessvolatile, hence a tightening of credit conditions will lead to higher equity volatility. When credit is easily available and rates are low, volatility remains suppressed, but as credit contracts, volatility rises.

I’ll leave you with a quote by Artemis…”Regardless of how it is measured, volatility reflects the difference between the world as we imagine it to be and the world that actually exists.”

I hope everyone had a wonderful Halloween! My one and a half-year-old took home the gold, as she brought in enough peanut M&M’s to last me a year!

If you’re interested in reading the entire Artemis Capital Management article you can do so by clicking this link.

The Forecast Report newsletter was originally published on November 10, 2017 by Jason C. Hilliard.

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