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Twin Bubble Meets Quantitative Tightening
Finding Hidden Value Stocks In Japan
Greenhaven Road Capital commentary for the third quarter ended September 30, 2022. Q3 2022 hedge fund letters, conferences and more Dear Fellow Investors, The Fund is enduring its worst drawdown since inception. We were down again in the third quarter, bringing year -to-date returns to approximately -59%. Returns vary by . . . SORRY! This Read More
1. Why Record-Low Volatility breeds Market Fragility
All-time lows in volatility for both Bonds and Equities may well represent the calm before the storm for markets. Ordinarily, low volatility and complacency themselves are necessary ingredients for market fragility, and the financial instability that follows. We explain why.
2. The Positive Feedback Loop between Fake Markets and investors creates System Instability, and Divergence from Equilibrium
Many fashionable investment strategies these days are not un-contingent to the artificial markets they operate within: ETFs, risk-parity, algo trend-chasing, machine learning, behavioral ARP, short-vol ETFs. As they successfully profit from an artificial set of variables, they cannot but derive as artificial a signal from it. In circular reference, artificial markets feed, and are fed, by a crowding effect in high-beta long-bias in disguise. In a downturn, they may likely play as hot-money or weak-hands, exacerbating a down-move. We look at different classes of investors.
3. When do we know these to be Delusional Markets
Signs of excess complacency are not difficult to spot. Among others, we look at covenant-lite loans, more than double what they were at the outset of the credit bubble in 2007
4. Sleepwalking through a Twin Bubble, as Quantitative Tightening nears
Fasanara thinks that markets move through a Twin Bubble, in both Bonds (especially in Europe) and Equities (especially in the US) simultaneously, and are therefore moving on a slippery slope. Markets have forgotten how much of current valuation is due to Quantitative Easing, at a time when QE is phased out. In the next months, the operating system for markets will move from Peak QE to Quantitative Tightening.
Also, markets are underestimating the climate change in monetary policymaking. The ‘wealth effect’ failed. While successful at avoiding an ugly deleveraging, QE did not spur a virtuous cycle in consumer spending, corporate profits, real wages, and inflation (except for financial assets). Meanwhile, it exacerbated ‘income inequality’, which helped the uprising of populists’ parties who now oppose it.
It is time to move to fiscal policy. However, nothing is as good as QE for risky assets: the liquidity tsunami that lifts all boats. Fiscal is uncertain in delivery and timing, in addition to be inflationary and tough to delink from higher rates.
Central Banks, differently than in the past, may be less keen to save the day for financial markets, or less keen to do so for mild sell-offs (within -20%). They may even use a weaker stock market as a top-down rebalancing act. Market participants believing that Central Banks have their back may be mistaken.
“Why, sometimes I’ve believed as many as six impossible things before breakfast.” - The White Queen, Through the Looking Glass, Lewis Carroll
Why Record-Low Volatility breeds Market Fragility, precedes System Instability
All-time lows in volatility for both Bonds and Equities may well represent the calm before the storm in the current set-up for markets. Ordinarily, low volatility and investors’ complacency themselves are necessary ingredients for market fragility and the financial instability that follows.
It does not work that different in weather patterns. At the root of the old sailors’ adage ‘calm before the storm’ is the fact that storms need warm, moist air as fuel, and they typically draw that air from the surrounding environment: “as the warm, moist air is pulled into a storm system, it leaves a low-pressure vacuum in its wake. The air travels up through the storm cloud and helps to fuel it”.
Similarly in financial markets, a state of low volatility presents the appearance of innocuous, ever-trending markets, which entices new swathes of unfitting investors in, mostly retail-type ‘weak hands’. Weak hands are investors who are brought to like an investments by certain characteristics which are uncommon to the specific investment itself, such as its featuring a low volatility.
It is in this form that we see bond-like investors looking at the stock market for yield pick-up purposes, magnetized by levels of realized volatility similar to what fixed income used to provide with during the Great Moderation.
It is in this form that Tech companies out of the US have started filling the coffers of not just Growth ETF, where they should rightfully reside, but also Momentum ETF, and even, incredibly, Low-Volatility ETF. However, tautologically, momentum must mean ‘until further notice’-type investment, thus ‘weak hands’. Low-volatility ETF is hardly associable to a high-octane investment rising 30% in 6–months: something does not add up, and may get squared off fast.
The reason why volatility is so low: forget benign macro, think of Fake Markets
The reasons why volatility across equity, bond, FX is close to all-time lows is being debated by market participants. A blue-sky macro environment is hardly a convincing explanation. The global market economy drowns in a level of debt without precedent, at 317% of GDP according to the IIF, while its marginal effectiveness in originating real growth has been falling for decades and is now the lowest on record at a fraction of any Dollar spent/borrowed to achieve it. Such debt accumulation resulted in an environment of chronic oversupply of anything from raw materials to goods, services, savings over investments, zombie companies. It does not stop here, as the picture is further aggravated by heightened geopolitical risks (end of Pax Americana), the rise of identity politics (populism and nationalism), the exhaustion of an experimental monetary policy as it reached capacity constraints, collateral damage, asset bubbles (end of Pax QE), the un-modellable disruption of the 4th industrial revolution.
In our Transformational Markets 2020, we tried to make sense of the transformational markets we live within, imagining how different from the status quo the 2020 market economy may look like. In our January Outlook, we argued that the macro environment of the next years will likely be influenced the most by structural trends such as:
- Protectionism, De-Globalization & De-Dollarization. In pursuit of Inclusive Growth
- End of ‘Pax Americana’. The ascent of China. Geopolitical risks on the rise
- End of ‘Pax Quantitative Easing’. Markets without steroids, but still delusional.
- 4th Industrial Revolution. US labor participation rate falling from 63% to 40% in 10 years?
In military parlance, U.S. Army War College used the acronym VUCA to describe the more Volatile, Uncertain, Complex and Ambiguous multilateral world which resulted from the end of the Cold War. It has been subsequently used to refer to systemic failures and behavioral failures, which are characteristic of organizational failure. We could think of current times to be peculiarly volatility-deficient but rich in all else, uncertainty, complexity and ambiguity. A new paradigm? We doubt it.
We can debate how big an impact can emanate from the combination of those structural trends, but hardly can we rationally associate a record-low historical volatility to such transformational markets. There is more to it.
Our take is that the more likely drivers of asset volatility, or the absence of it, are the fourth horsemen of easy monetary policy:
- the unprecedented magnitude of Central Banks’ activism. For all the talk about QE tapering, we currently live through Peak Quantitative Easing, it was never before this high: $300bn+ monthly asset purchases, or annualized passive flows for $3.7trn globally
- the ensuing rising mania for passive investment vehicles: the tulips of ETFs and passive index funds, Risk Parity funds & Vol Levers of all types, Algos (two-thirds of which are trend-chasing), machine learning shops (learning that buy-the dip works). We count close to $8trn of firepower globally. As we discuss later in this piece, they share a common long-bias in commercial disguise, in addition to an itch for rising correlations and volatility.
- the ensuing capitulation of active investors who default to chase passive ones, as they fall prey to mental loops like ‘recency bias’ and ‘induction trap’
- the power of make-believe economic narratives, rigorously ex-post: from chasing yields, to chasing growth, to chasing earnings.
We attempt at explaining their sequence and interdependence here. ‘Fake Markets’ are defined as markets where the magnitude and duration of artificial flows from global Central Banks or passive investment vehicles managed to overwhelm and narcotize data-dependency and macro factors. A stuporous state of durable, un-volatile over-valuation, arrested activity, unconsciousness produced by the influence of artificial money flows. We discussed it further in a recent interview.
See the full PDF below.