As Bank of America Merrill Lynch’s Benjamin Bowler looks at the placid, quantitatively engineered markets and correlates it with the unusual geopolitical and regional occurrences that have transformed the landscape, he emerges with one central thought. “Risk is not fake news,” he concludes in the title of a December 6 research piece. The derivatives expert can see through the market’s fog and he is concerned amid a world where “volatility across asset classes has decoupled from uncertainty.” With all these odd market bending concepts acting like dopamine, Bowler thinks risk management thoughts as he speculates on forthcoming market crashes and the opportunity to buy on a drawdown, a classic derivatives strategy that has meaningful risk itself.
When investors no longer fear risk, should we be worried?
The core performance driver behind volatility is surprise. When markets anticipate an event, statistically speaking hasn't led to meaningful past volatility. But a component of surprise is uncertainty, which has always been a market anathema as well. So when he sees a market anathema decoupled from price performance he becomes suspicious.
Bowler comes from a "derivatives school" of thinking, which is apparent in how he looks at the current market constructs and scratches his head.
“Investors no longer fear risk but love it,” he points out, noting a perverse buy on the drawdown mentality that is driven by an expectation for mean reversion. Can investors count on a market price readjustment resulting in a buying opportunity?
Bowler thinks so.
“Growth tailwinds (aided by US tax reform) absent inflation could keep dip-buying and the cycle of no-fear alive,” he thinks. But to understand this trade with difficult timing requires an understanding of central bank stimulus, which points to a timing issue.
Abnormally low market volatility is sending messages
From Bowler’s standpoint, low volatility amid a generally uncertain world is masking the potential for a market event:
Even if seemingly irrational, apathy to all risk has been the right trade and an impossible trend for most to fight – the definition of a bubble. Markets remain fragile but Aug-15 a bigger risk than ’87 Markets remain fragile owing to crowding, low liquidity and low confidence. The risk of an Aug-15 style shock is real. However, fears of a 1987 style crash due to excessive “short-vol” positioning may be overdone. History also suggests shocks are limited by the volatility preceding them, making an ’87 crash today equivalent to only a 5% sell-off.
While Bowler looks at the innards of market structure and determines volatility is pointing to a correction, volatility is interpreted in different ways.
Mandy Xu, chief equity derivatives strategist at Credit Suisse, looks at low volatility and notes that “extreme sector dispersion explains why index moves have been so muted this year
"There is much volatility in the stock market, she reasoned, but when noncorrelated volatility factors are combined in a stock market index, they cancel each other out. From this standpoint, historically low volatility doesn’t concern her.
Brower, however, thinks that markets are experiencing a blanket of low volatility that has resulted from central bank market bending:
Long-term, vol may be stunted in a low growth world.
Unprecedented central bank (CB) policy and its inability to drive more growth & inflation created today’s perverse conditions. But CBs are pulling back and G4 balance sheets are likely to peak in Q1 ’18. With the Fed continuing to hike, building monetary ammunition and gaining confidence markets can cope, their put strike is falling. Unexpected inflation is the big risk for low vol. However, in the long-run, vol follows yields. Hence while VIX at 9 is a bubble, VIX at 20 (its long-term avg) may be unsustainable in a low rates world. Timing end still hard as shock needed to break psychology.
The timing of this market event is imperfect, at best, so don’t try this stunt at home. “The belief that risk doesn’t exist is a collective psychology and it may take a significant shock to make CB’s waning support visible,” he said, pointing to a key to Yellen’s deft success at slowly withdrawing the market dependent drug. “This makes calling the exact end challenging. We favor strategies that don’t need to nail the timing.”