by Jeffrey Miller, Partner, Eight Bridges Capital Management
June 13th, 2017

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First, apologies for skipping an edition of the Musings.  Life has been hectic, with traveling to visit company management teams.  And really, there wasn’t a lot to say – markets have been calm and quiet lately.  If you don’t have anything important to say…you know the rest.

“There is nothing more deceptive than an obvious fact.”
Arthur Conan Doyle, The Boscombe Valley Mystery

There are some obvious facts about the U.S. stock market that are fairly deceptive.  Maybe the most deceptive of them is that recent low volatility does not portend future low volatility – in other words, if the recent past has been calm, the near future may not also be calm.  And yet, that is precisely what multiple market indicators of future volatility are pricing in.  What is deceptive about this market is that while the overall S&P 500 continues to move in a very narrow, low-vol range, the underlying sectors are swirling around fairly rapidly.  This is leading funds and strategies that aspire to control the volatility of their own returns to become overly comfortable with the market.  If these strategies were small relative to the size of the stock market, it really wouldn’t matter.  But according to the Wall Street Journal, “volatility control” funds that use the VIX to decide whether or not to buy stocks now have $200 billion in assets.  That is in addition to the trend following strategies being used by pension funds and risk-parity funds that increase their leverage during periods of expected low volatility.

“’Is there any point to which you would wish to draw my attention?'

'To the curious incident of the dog in the night-time.'

'The dog did nothing in the night-time.'

'That was the curious incident,' remarked Sherlock Holmes.”
Arthur Conan Doyle, Silver Blaze

This crowding into the low-vol trade will only be problematic when volatility spikes and remains high for a significant period of time (i.e., more than a few days).  When will that happen?  I have no idea.  The sell-off in the ever-evolving cohort of FANG/FAAMG (Facebook, Amazon, Netflix and Google, or Facebook, Amazon, Apple, Microsoft and Google, depending on who is using the acronym) on Friday was sharp and, relative to recent trading, deep.  But a rally in financial and energy stocks, which have been the two worst performing sectors year-to-date in the SPX, offset the tech declines – keeping overall SPX vol low.   So the low vol trade continues to work, until it doesn’t.  Put another way, the dog did nothing in the night time, which is a curious thing.

The concern I have is that when the low-vol trade eventually doesn’t work, it’s going to blow up spectacularly, as, compared to past market downturns, there is a lot of money betting on stability.  What that means is that, past a certain point, the selloff will accelerate, as put sellers either hedge or get margin calls.  Some would argue that the recent surge in “passive” investing via index funds and ETFs will acerbate that eventual selloff, but I’m not so sure – we have had spectacular crashes in the past, well before Vanguard created an index fund.  What may be different this time is the speed with which it occurs – think Black Monday, 1987, not the relatively more gradual declines of 2000.

So why am I so sure that eventually we’ll have a severe decline?  Mainly because there aren’t many cheap stocks anymore.  Value investors (and I think of myself as one of those) prefer to invest when the math on an IRR basis is easy, and right now that math is hard to make work.  At current prices, value investors are having a difficult time finding stocks that they feel confident in buying and holding.  Many value mutual fund managers I talk to are just putting money to work because they have to, not because they want to. Growth has massively outperformed value recently, exacerbating the relative performance problem and driving the aforementioned FAAMG cohort to spectacular year-to-date returns. Unfortunately, what this means is that in a sell-off, value investors aren’t going to be interested until stocks fall a large amount.  When stocks are cheap, value investors are in there picking away at their favorites, and are probably getting money flows to boot if they have recently had good performance (which they tend to do when stocks are cheap).  But in the current market, stocks aren’t cheap, value funds are bleeding cash, and the funds that invest using momentum factors and other trend following systems will all get sell signals at the same time – creating a self-reinforcing negative feedback loop.  The market may well then become reflexive, where stocks going down makes them less attractive to the investors that have been getting money, while the investors that normally step in as prices go lower are already fully invested or don’t have the firepower to stem a decline.  The flow of funds out of active managers and into passive investments is one risk factor that will create this negative feedback loop (index funds don’t hold cash, for example), while the amount of money in “vol control” and vol selling strategies is another.  The combination could create some breathtakingly fast declines.  Buckle up.

“How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth?”
Arthur Conan Doyle, The Sign of Four

At this point you can probably tell that I think it is impossible that volatility will remain near record lows forever.  So what is left that, while being improbable, must be the truth?  Having spent a lot of time lately thinking about the current state of financial markets, I think the risk that most (but not all) market observers view as improbable is that Central Bankers around the world will lose control of their bond markets.  Put another way, I think that most market participants are paying extremely high prices for credit of all types, from Sovereign bonds with negative yields to Investment Grade Corporates (IG) yielding 1% over equivalent sovereigns to High Yield (HY) bonds near (but not quite at) all-time tights, because they think that central banks are infallible.  Long-time readers know I have been pointing at these markets as incredibly overvalued (I think the next “big short” will turn out to be European Sovereign bonds with negative yields and High Yield), but so far have been wrong, mainly because the bond market continues to believe, as a whole, that the central bank “put” will always be there.  The market is pricing in the fact that it is extremely improbable that rates will ever rise meaningfully again. However, when thinking through the various likely future outcomes for financial markets, one scenario continues to strike me as the most likely: that financial markets swiftly, synchronously sell off – a flash crash across global markets that central bankers are unable to stop before bonds are off 15% and stocks are off more than 20%. When will this happen?  Probably not until the ECB or Fed start to meaningfully unwind their $14 trillion in bond holdings.  If they never do, but continue to “buy buy buy,” literally forever, then maybe the

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