August 16, 2020

The Return of Volatility

What a week it has been! Explanations abound for the market’s dive and the return of volatility. Most comments blame rising interest rates and worries about inflation juxtaposed against valuations that had swooned in the last two months.

Indeed, the sell-off started right after the US Labor Department reported strong job growth in January and revised December’s numbers up, while also reporting that average hourly earnings rose 2.9%. For years the economy has repeatedly failed to meet inflation targets; to suddenly not only meet but beat expectations was, I guess, more than the market could handle.

That’s fair enough as a starting point. It’s also fair enough to state that the parabolic gains of December and January were never going to just keep going, and moves like that rarely taper gently – they correct.
However, while interest rates and inflation are playing a role, there’s a bigger picture that I think deserves comment.

The biggest trade of recent years has been to short volatility. To short is to bet against. After spiking to 60 in the financial crisis, volatility as per VIX (the CBOE Volatility Index) has held one clear trend: down. And seven years of decline had taken volatility to record lows.

A trend like that attracts interest. And in a modern market in love with investment products, the interest meant an explosion of strategies and leveraged funds that shorted volatility, relied on a downward volatility trend, or were based in declining-risk equity bets.

In itself, this short-vol obsession was interesting (scary?) enough. The fact that it happened at the same time that index trading exploded (there are now more ETFs than there are publicly-traded companies – let that sink in for a minute) created an investment universe incredibly biased to low risk and no volatility.

If you can believe it, estimates suggest some $2 billion flowed into ETFs and ETNs (exchange structured notes) designed to benefit from decreasing volatility in January alone.

That all worked really well…until Friday and Monday, when volatility returned.

I’ve spent a lot of time in the last few days reading and my favorite quote summarized trading volatility for the last six years, during which time XIV (an inverse Volatility Index product) rose from $10 to $144 before plummeting to almost zero yesterday:

“Six years of picking up pennies in front of a bulldozer wiped away in one session.”
— blogger Quoth the Raven, on Twitter

Fund manager Douglas Kass has been warning for over a year now that all this volatility betting combined with index and ETF inflows and quant trading could create a flash crash. As he explained (yet again) in a note on Friday, the massive and fundamental shift to passive investing in recent years culminated in a “buyers’ panic” in January, as late-to-the-party retail investors (suffering from Fear Of Missing Out) poured a record $50 billion into domestic equity funds.

You might think a flood of money of that magnitude would show up in liquidity and volatility…but the opposite happened: market volumes declined and volatility was non-existent. The lack of liquidity exaggerated gains, creating a parabolic run-up in January:

The collapse of this run up and the resulting spike in volatility – and the money it erased in all those short-volatility-based ETFs and ETNs – could well have tamed the short vol trade going forward. If so, I’ll take it. All this short-vol trading came from a market that had decided stocks didn’t involve risk. But they do. They always do. And for that reality to return is a good thing.

It’s also the beginning of the end of the bull market, but that process could still take a long time. In fact, it will likely take a while. Global economic growth is finally happening. That is adding a lot of confidence to market that was already full of swagger. Unless something crops up to destroy that confidence (like a mortgage-backed security maelstrom), this has the makings of a bull market that slows but continues, making another peak or three but correcting in between as investors get increasingly wary of risk and start turning to safer havens.

Adding into the big picture is the fact that Treasuries are looking more attractive. In fact, for the first time since 2008, US 2-Year Treasuries are yielding more (2.09%) than the average dividend yield from the S&P (1.8%).

That kind of shift takes time to really manifest, but as investors get more risk adverse they look for exactly this kind of transition. It’s a bit of a self-moderating phenomenon, of course, because increased buying makes Treasury prices rise and yields fall, but if interest rates continue to rise amidst a more risk-wary environment, the search for security and yield will always shift interest to bonds.

If this big-picture shift is indeed underway, if this correction brings risk awareness back to the market, then the rest of this bull market will be marked by considerably more volatility. The later stages of a bull market always involve more volatility – the peaks and corrections of greed and fear do that, fueled by confidence in economic acceleration and concerns about rising interest rates and inflation.

Volatility is not bad in itself. In fact, for the metals investor today I would suggest that the return of volatility is good. We need investors to get a bit spooked. As long as fear stayed on the sidelines, investors were going to keep doing more of the same. The return of fear will disrupt the mantra that the rising tide is lifting all boats; value stocks and income stocks will start to stand out versus growth stocks and broad baskets.

And the search for value will bring investors to metals and miners. There is just no other way. I’ve laid the arguments out in the last few issues so I won’t rehash them here, but the mining sector offers rare value in an overvalued market, reliably outperforms in the late stages of an economic expansion, and is supported by a weaker dollar and inflation concerns. Add to that the safe haven argument for gold and the entire metals complex is set up to do well.

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