A Top CRO Weighs in on Volatility
Regulators, central banks, and politicians are all shocked!! by the volatility that we have seen recently in the markets. And they’re searching for big, bad, nasty financial-institution culprits who must be making themselves rich by creating instruments that have taken advantage of retail investors and magnified liquidity.
The reality is that this situation is far more complex. Yes, the change in the underlying structure of the financial markets has materially increased short-term volatility. But it’s the systemically risky actions of central banks and politicians that have created an environment with the potential for long-lasting reductions in value for virtually all asset classes. And it’s that environment and the very real fear of adverse outcomes that’s driving heightened volatility in markets.
Let’s start our analysis of heightened volatility with the implications of current policy and then examine the subtler implications of the evolution of the structure of markets.
Irresponsible Central Banks and Complicit Politicians
Central banks keeping interest rates at historic lows for prolonged periods of time to avoid recessions and create growth seems like a great idea… unless it comes at the cost of unprecedented market participation by those banks.
In Japan, almost all of the new government debt is purchased by the Bank of Japan and held on its balance sheet. While this is quantitative easing taken to the extreme, similar (although less all-encompassing) constructs have been at work with European central banks and the Fed, with quantitative easing broadened to include purchases of other asset classes such as mortgages, corporate debt, and even equities.
The danger of this is that we have created a system of distorted values across virtually all asset classes. Very low interest rates change expectations of return and drive valuations higher.
The danger of this is that we have created a system of distorted values across virtually all asset classes. Very low interest rates change expectations of return and drive valuations higher. Discounting cash flows at 3% instead of 6% doubles the valuation.
Why is this a problem? Because the activities of the central banks are sustainable only if we live in a world where their ability to print currency is infinite – and without a change in the currency’s value. Indeed, this has seemed to be the case over the last 30 years in developed countries. And many economists will try to convince you that it can continue indefinitely. It cannot.
There are many, many frightening cases of this story not ending well. Inflation in that economic-disaster zone, Venezuela, is currently running at an annual rate of more than 4,000%. Argentina and Brazil – two countries that should be much richer than they are – have both suffered multiple episodes of hyperinflation. In Germany, during the Weimar Republic, such inflation had catastrophic effects not only on asset valuations but on societal structures and political systems.
Investors feel this fear of inflation acutely and as a result many have become central-bank watchers. The analysis of an individual company’s relative performance matters less for its valuation than the implications of heightened interest rates on that valuation.
Investors are truly in a damned-if-they-do and damned-if-they-don’t world. Betting against the central banks’ ability to print money continuously without reducing its value has been a fool’s errand for 30 years. And those who made that bet are now no longer managing money.
At the forefront of investors’ minds is the very real fear that at some point the 30-year lowering of rates must end. Then the effects of central bank market participation will create a rapid change in the supply and demand equation for government debt and drive rates higher and asset values lower. Investors hold stocks and bonds but are ready to react at the first whiff of a back-up in rates. This is a recipe for heightened volatility that will, absent a severe market correction, continue unabated.
The Evolution of Volatility
Well into the late 1980s, there were significant frictional costs in trading stocks and bonds. The costs came both in dollar terms and in terms of the technology used. Back then a certificate would have to be found, notated, and delivered to the window at the exchange, then traded, then reissued – pretty painful stuff. Today all that happens in the blink of an eye with frictional costs in time, money, and effort so small that I would almost say we are frictionless.
Many brokers offer free trades on the retail side, and on the wholesale side very large blocks trade today for very low cost. And on the physical side… The physical side no longer exists!
Delivery and notation of certificates has been replaced by electrons flying through space with instantaneous outcomes, and by assets moving Harry Potter-style through the air from one account to another. Shorting stocks has become far easier, with many instruments available so that one can synthetically reproduce the outcome.
News cycles have gone from lengthy to instantaneous, and the proliferation of market “news” programs has made everyone aware of what is happening at all times.
Consider broad-base challenges today. Everyone can get in or out of markets in a heartbeat. Also, the instruments available have changed… You can buy and sell the index… futures on the index… in a nanosecond… You get the idea.
In 1929, if you wanted to lever a stock you had to borrow the money to do so. Of course, in those days there was virtually no constraint on how much money you could borrow. Today, you can only borrow 50% of a stock’s value, but the margin process remains every bit as volatile.
As stocks fall, you must instantaneously post collateral. Pooled investments in “40 Act” funds routinely carry leverage through the so-called “130/30 Strategy” of using proceeds from short sales to go long on stocks that are supposed to outperform the market.
Why is leverage a problem? Because it creates irreversible trends when prices start to fall. As the market declines, people are forced to sell to cover collateral calls. One type of forced selling begets other types… sales by individual investors who put in stop-loss provisions to sell an asset when its value falls 10 or 20 percent. Another type is sales by volatility funds controlled by the idea that when the VIX climbs above a certain level, you sell. Or sales resulting from the algorithm that tracks 200-day moving averages, or from any of the other “technicals” that supposedly indicate when to buy or sell. Plus, you’ll have sales from programmatic trades that follow valuation metrics. And so on…
Nearly every wholesale market participant has some version of an “automatically triggered sell.” And also, of course, an “automatically triggered buy.” Leverage pulls one trigger. Then an algorithm pulls the other. Volatility comes at a machinegun rate.
Yet it is important to remember what drove these changes and who has benefited. The drive to reduce the frictional costs in trading and execution has ultimately benefited the retail investor. NYSE specialist firms and floor brokers with seats on the exchange have become largely irrelevant to the market and wholly irrelevant to the economy. Large broker-dealer firms have watched the bid-ask spreads shrink to where it is almost impossible to make a living in the execution business. The beneficiaries of this are, in the end, investors.
Digitalization of order flow and stop-loss orders have, again, reduced the cost for investors while creating dynamic risk protection schemes as markets decline.
Algorithm and volatility fund investment schemes are another means for end investors to participate in markets while managing the risk of a potential decline.
So, while frictionless market participation, digitalization, and the proliferation of downside protection schemes have undoubtedly increased short-term volatility, they have also made markets more democratic and safer. Yes, the chances for short-term market dislocations have increased, but the ability for markets to repair themselves has expanded.
The good news is that while the changes in market structure have and will continue to exacerbate short-term market volatility, the chances of these changes leading to lower valuations through time are very low. In fact, it is far easier to make the argument that valuations will be higher due to the democratization of markets and the confidence given to investors by their ability to manage downside risk.
The bad news is that it is hard to see an end to the heightened volatility brought on by central bank and policy actions over the last 30 years. And, what’s worse, those actions have the very real potential to convert heightened short-term volatility into a very long period of reduced valuations which will have real consequences for the economy.