Two weeks ago, we discussed the recent report from Artemis Capital Management, ‘Volatility and the Alchemy of Risk – Reflexivity in the Shadows of Black Monday 1987’, authored by Christopher Cole. See ‘In the Shadows Of Black Monday – ‘Volatility Isn’t Broken… The Market Is’. The full report can be accessed here.
Perhaps because we posted it on a weekend, we feel that this must read report – one of the best reports we’ve read in years – has not received the profile it deserves. We think that it’s important to highlight it again, as it explains the mechanics which are likely to drive the next financial crisis. We begin with a ten bullet point summary.
In the Global Short Volatility Bubble:
We are in an unprecedented bear market in fear, i.e. falling volatility, thanks to the unconventional monetary policies of central banks; Instead of being an external measure of risk, volatility has become a tradeable input – making it reflexive in nature; As volatility falls, investors (using leverage) take bigger bets in the same direction, so lower volatility begets lower volatility. The global short volatility trade is more than $2 trillion; It consists of explicit short volatility trades and implicit short volatility trades, e.g. risk parity and accumulated equity share buybacks (price insensitive/buy the dip); Due to reflexivity, in any shock to the system which starts an unwind in the global short volatility trade, higher volatility will reinforce higher volatility; The markets are effectively converging into what’s known in option markets as a ‘naked short straddle’ – as volatility declines, the upfront premium (yield) declines while non-linear risk rises; Non-linear risk has four components – rising volatility, gamma risk, unstable cross-asset correlations and rising interest rates; Volatility is the most undervalued asset class in the world; The unwind of the global short volatility trade would lead to a sudden hyper-crash, similar but worse than 1987. It’s become fairly common for the current central bank-created bubble in financial markets to be labelled the ‘Everything Bubble’. We can’t remember who coined the phrase, it might have been John Hussman, who describes current financial conditions as ‘the most broadly overvalued moment in market history’. No matter, here is one representation from the portfolio managers at Incrementum AG.
This post was published at Zero Hedge on Nov 6, 2017.