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EspressoLover


Total Posts: 240
Joined: Jan 2015
 
Posted: 2017-08-18 20:12
Volatility and trading activity seem to be stuck near all time lows. Not that there aren't some sparks here or there, but the market seems enormously resilient. Nuclear war, terrorism, monetary tightening, nosebleed valuations, insane political drama that would be too implausible for a Tom Clancy novel. At most it drives one or two days of risk-off, then the market shrugs it off and hits new highs.

I would guess that for most people here, myself included, this state of affairs kinda sucks. So time for rampant speculation and bullshitting. Because what else are you gonna do right now. First question, what's up to cause all of this? It seems like there's a million and one explanations for what's happening: animal spirits, decline of active investing, shortage of safe assets, smart beta, Chinese capital outflows, shifting demographics, the Yellen put, DM stocks being the only decent investment left, algo trading smoothing out disruptions, sector rotation replacing risk-on/risk-off, etc. What's your favorite explanations?

Second question: Is this time different? History says vol may be low now, but markets will eventually revert back to a very stable long-term average. Are we just in a temporary cycle, or is there a permanent shift? This probably ties in closely with your answer to the first question. If you believe that this is due to passive indexing or smart beta, these are technologies that weren't widely utilized until recently. In which case this time may very well be different. The equity risk premium (along with its contributions to volatility) may very well be a thing of the past. Erased by widespread adoption of rational disciplined and systematic investment strategies.

Nobody's going to have a definitive answer, but there's a lot of insightful people here. So, what say you?

ronin


Total Posts: 216
Joined: May 2006
 
Posted: 2017-08-18 21:54
>Because what else are you gonna do right now.

Take a vacation. @el, you should try it some time. I happen to be writing this from my terrace, just above a beach, on a small island, somewhere in the Mediterranean.

But I get what you mean. I have barely been here for two weeks, and I am already bored.

So you can have my 2p.

q1. Valuations are too high, so you'd be crazy to go long. But short sellers are getting hammered, so you don't go short either. As an investor (as opposed to trader), what would you do?

We were actually looking at single digit credit spreads and VIX approaching single digits.

Will VIX hit single digits, or won't it? Should we go long if it does? Then it did.

Still, forwards were around 15 or so - not a buy. We all agreed - those forwards are more likely to expire around 10 than 20.

That was in 2006. That time it was different too. Lots of reasons why low volatility was there to stay.

q2. I don't see how passive investing can drive volatility in any serious way. To first order, dollar variance of the markets is proportional to the dollar value of the amounts traded.

Passive investing hasn't driven people in or out of the market - it has just put more poeple in the same products, who would 10 years ago have been taking their individual best bets.

So I see passive investing driving dispersion, but not overall volatility.

Actually I think that the trend into passive investing is the most cyclical thing of all. Why pay 2 and 20 to somebody who is struggling to generate positive returns when you can pay 10 bps for SPX trackers with Sharpe 5?

But when SPX drops 70% or so of its value, people will drop passive trackers like hot potatoes. It's just that we are not at that stage of the cycle yet.


"People say nothing's impossible, but I do nothing every day" --Winnie The Pooh

Praetorian


Total Posts: 224
Joined: Apr 2009
 
Posted: 2017-08-19 18:01
I think this time is not different than any time before. My guess is, that the passive investing crowd will still get stronger before it all ends in tears. Like every crowded space before. Remember portfolio insurance and what happened when the masses rushed to the exits?

I read that some CEOs try to optimize their stock options by optimizing against some off-balance shit in ETFs. If it gets manufactured like this, the next cycle might be quite near.

chiral3
Founding Member

Total Posts: 5009
Joined: Mar 2004
 
Posted: 2017-08-19 18:30
I'll throw some other ideas in - manly US vol centric:

Top down - central banking and monetary policy. Lots of talk about stock sensitivity to rates, but CB/QE have driven assets prices. Most of my discussions in the last year of so have been around macroeconomic drivers, terror, etc. Very little bottom up with the exception of the upside risk...

Bottom up - low index correlation driven by the top X of a market cap weighted index pulling most of the returns. Short vol strats outperforming (momentum and vol smart beta), being pegged to bond yields, and the requisite hedging within these strats pushing rv down. VIX is basically a proxy for realized. 1y rv @ 7%-10% p.a. against late teen iv's. Upside risk.

It'll be interesting to see what happens to the shape of the curve. With no QE, reinvestment, QE assets rolling off, etc. very little inflationary pressure, and valuations where they are, it's hard to see where the vol could come from unless we make it up somehow. Bullshit sentiment and global calamities are the only obvious drivers from my perspective. I think we'll see a bunch of inorganic value emerging as M&A, particularly in the PE space, continues to play shell games in the US. Flight to quality, assuming EM/EAFE isn't at the high will continues to make "money out" attractive. All this with the footnote that there's a ton of uninvested cash.

IOW, no end in sight. We do know that when it does happen, though, it doesn't happen gradually.

Nonius is Satoshi Nakamoto. 物の哀れ

HitmanH


Total Posts: 430
Joined: Apr 2005
 
Posted: 2017-08-20 09:52
Ronin - you say "I see passive investing driving dispersion, but not overall volatility" - that is interesting - and not how I look at it.
Looking at passive as more of an index product (as opposed to 'smart' beta'), then my take is that it reduces dispersion - as everything is dragged up / pushed down the same, regardless of 'quality', or some other single stock alpha that you focus on and believes drives differing micro results/performance

Cheng


Total Posts: 2835
Joined: Feb 2005
 
Posted: 2017-08-20 12:02
Is this time different?

The four most dangerous words in investing: This time is different.

"He's man, he's a kid / Wanna bang with you / Headbanging man" (Grave Digger, Headbanging Man)

chiral3
Founding Member

Total Posts: 5009
Joined: Mar 2004
 
Posted: 2017-08-20 16:37
It's never different, it just feels new and different for the latest and greatest.

I was getting talked at by some 28 year old vol trader at GS the other day. Shocking how little perspective they had. Equally shocking how old she made me feel.

Nonius is Satoshi Nakamoto. 物の哀れ

goldorak


Total Posts: 991
Joined: Nov 2004
 
Posted: 2017-08-20 17:56
My view is the following on the current situation. It is here to stay. Mimicking others has become too easy and herd sheep behavior is stronger than ever.

- Financial information is available to anybody, anywhere and at the same time (at least at human scale). Used not to be the case.
- Research and ideas are easy to access. Remember the good old days of looking for photocopy of academic papers from the local library? Nowadays you just receive your daily feeds, and even worse, everybody is reading the same feeds (no, alphaarchitect.com don't understand shit about what they read).
- Computing power is cheap. Remember the 90s and all the excitement going around that new Solaris workstation ordered 6 months ago that would allow you to fit that big correlation matrix in memory?
- Consultants hold the market and tell people how they should think. FoHF included. Btw, what they tell you today is light years away from what they were telling you 10 years ago (remember the diversification properties of commodities and hedge funds in your portfolio?)

To make a long story short, everybody listens to the same experts who are famous for knowing what happened yesterday, reads the same literature, uses the same tools and trades the same markets. What else would you expect from such behavior than plain lethargy with few gasps? The very notion of risk is now corrupted and misinterpreted by most people involved in finance.



Just to mention. If the S&P 500 had been a hedge fund manager, it would have closed shop a long time ago... but this is the kind of sentence that "institutional" investors do not want to hear.


If you are not living on the edge you are taking up too much space.

chiral3
Founding Member

Total Posts: 5009
Joined: Mar 2004
 
Posted: 2017-08-20 20:05
Your fourth point is a great one and probably under-appreciated by many. It's always been true - HBS drove herd M&A, if you want to defeat the US Army get the Ranger's field manual, etc - but even more so with the outsourcing of IP since the 90's. The marketing machine makes it all look and sound different, but buying a trunk or a tail is still buying an elephant.

Nonius is Satoshi Nakamoto. 物の哀れ

TSWP


Total Posts: 370
Joined: May 2012
 
Posted: 2017-08-21 10:22
I don't think you can figure out what is going to happen next.

Predicting future market behavior with rationality it's a delusional exercise.



ronin


Total Posts: 216
Joined: May 2006
 
Posted: 2017-08-21 10:30
@HitmanH,

I think we agree on this one - I may have been unclear about the direction in which passive flows drive the dispersion. It's down, not up.

So the basic idea is that it's all the same old flows, only now they all go to the same stocks in the same proportions.

The argument would be that, if anything, passive flows increase index volatility through decreased diversification. But it is a small effect, probably too small to measure accurately.

Do you see a direct effect on volatility, other than through correlation? How?



"People say nothing's impossible, but I do nothing every day" --Winnie The Pooh

EspressoLover


Total Posts: 240
Joined: Jan 2015
 
Posted: 2017-08-22 02:18
Very insightful replies all around. Threads like this are what makes this phorum great!

Like most here, I'm leaning hard against the "this time is different" hypothesis. That being said, I don't think it can be ruled out off the bat. Academic finance is pretty clear about two things: 1) the equity risk premium is too large to be rational. 2) Only a small proportion of the variance comes from changes to future cash flow expectations. Most of it can be attributed to fluctuations in the discount rate.

It seems plausible that at one point in the (maybe, quite far) future, investors will get over their equity-averse superstitions and permanetely bid the equity risk premium to near zero. In which case, a major sub-component of market volatility will simply disappear. Who knows when, or if, that will ever happen. But if it does, the cultural sea change will probably look a lot like a massive market share grab by passive indexers. Homo economicus forgets about trying to pick the hot manager of the hour, socks away his investments in a low-fee index fund, and only checks his statements once a decade.

(For the record, I'll entertain this theory, but don't really believe it. I think we're just in a massive bull market. Money tends to chases five year performance. Most active managers, particularly in alts-space, are <1.0 beta. Index funds, being 1.0 beta, are going to be where hot money lives for now. Until, as ronin mentioned, we see a big pullback.)

On the other note, I would contend that actives still create more index vol than passives. Even for funds with full-investment mandates. Actives can still make trades that are dollar neutral, but beta directional. For example a defensively positioned manager rotating out of consumer cyclicals into utilities. It doesn't directly affect a cap-weighted index, but there's still second-order effects at play. That's a pretty clear signal that's going to be internalized during index price discovery.

Neither passives or full-mandated actives participate in index price discovery. They're perfectly price inelastic, and have to remain 100% invested regardless of valuation. (Notwithstanding their investor commitment/redemptions.) However, unless all stocks have a 1.0 beta, then there must exist arbitrageurs keeping individual stock returns in line with [beta*market-return]. But that process also works in the other direction. The same arbitrage activity will push market returns in line with [sum(beta*stock-return)]. I'd argue that active rotation can still generate index volatility through this channel.

Cheng


Total Posts: 2835
Joined: Feb 2005
 
Posted: 2017-08-22 09:10
To make a long story short, everybody listens to the same experts who are famous for knowing what happened yesterday, reads the same literature, uses the same tools and trades the same markets. What else would you expect from such behavior than plain lethargy with few gasps? The very notion of risk is now corrupted and misinterpreted by most people involved in finance.

Which should make it easier for people who think for themselves and ignore the crowd, no? Note that I don't say that you should do the exact opposite of what everybody else is doing. If everybody is running to the left running to the right is not the best decision by default, there are more possibilities.

"He's man, he's a kid / Wanna bang with you / Headbanging man" (Grave Digger, Headbanging Man)

goldorak


Total Posts: 991
Joined: Nov 2004
 
Posted: 2017-08-22 13:59
You better do things differently, or end up like AQR or GS in August 2007. A nice kick in the ass to these guys and their arrogance it was indeed.

And I would definitely advise against "betting against the crowd" in most cases.



If you are not living on the edge you are taking up too much space.

AndyM


Total Posts: 2319
Joined: Mar 2004
 
Posted: 2017-08-24 17:25
Having probably read more 'Death of Volatility' takes over the years than most here, I feel fairly confident asserting that this too shall pass.

Innovation and microstructural changes don't tend to affect the baseline level of volatility as such; they just shovel it into the tails. In fact, one could argue that most financial innovation does not much more than shovel vol into the tails. So we get a moderation and then a blowup, and then another moderation etc. The details change each cycle but the outlines remain the same. We had this same discussion in the mid-90s and the mid-00s. If it was 1987, we'd probably all be complaining that portfolio insurance is killing volatility.

Now, whether markets can stay becalmed longer than you can recoup your fixed costs is another question.

I used to be disgusted; now I try to be amused...

Maggette


Total Posts: 959
Joined: Jun 2007
 
Posted: 2017-08-24 21:49
INMHO there is something very deep in AndyMs post regarding tails and financial inovations, even though I can't really grasp it.

It reminds me of something in "Why stock markets crash" by Didier Sornette. Some west coast state in the US (don't recall which one) realized it is better not to fight every wildfire as soon as it is detected. They let small fires burn. But these islands of burned woodland serve as protection belts from new wild fires. They do not get that big any more.

Same in software development with the "fail fast" approach.

I think at present we have established a system that allows the pile of shit to grow larger than normal before it collapses....but if it breaks down it is even a more massive cluster fuck (like monolitic corporate spanning software project that spreads like cancer or protecting massive square miles of dry woodland until it burns down out of control)

Ich kam hierher und sah dich und deine Leute lächeln, und sagte mir: Maggette, scheiss auf den small talk, lass lieber deine Fäuste sprechen...

EspressoLover


Total Posts: 240
Joined: Jan 2015
 
Posted: 2017-08-24 23:38
It's a seductively compelling theory, but the empirical support is pretty weak. I decided to look at daily S&P 500 returns by decade going back to 1950. Here's standardized excess kurtosis by decade:

1950s: 9.3
1960s: 11.9
1970s: 5.3
1980s: 58.7
1990s: 7.8
2000s: 10.8
2010s: 7.3

And the same for monthly returns, which is a little cleaner and not so dependent on the single largest days:

1950s: -0.6
1960s: -0.2
1970s: 1.2
1980s: 2.6
1990s: 0.5
2000s: 1.6
2010s: 0.5

There's not really any clear evidence of a secular trend towards fatter tails. At least not in a statistical sense. The peak of tail-driven volatility is still 1987. Even 2008 pales in comparison for leptokurtosis. If the story is that financial innovation fattens the tail, surely three decades of market evolution should have pushed us to new heights. Looking at the distant past: yes, the fifties and sixties are relatively thin-tailed. But my guess is this is mostly an artifact of when the time series starts. I'd really doubt that the two world wars, 1929 crash, and Great Depression would be platykurtic.

involution


Total Posts: 4
Joined: Nov 2015
 
Posted: 2017-08-25 07:11
https://www.youtube.com/watch?v=27x632vOjXk#t=16m15s has an interesting chart of s&p drawdowns going back to 1850

ronin


Total Posts: 216
Joined: May 2006
 
Posted: 2017-08-25 15:35
I am not sure if kurtosis is the right measure though. Long periods of low volatility fatten up the centre and kill the kurtosis.

You want some measure of "hatness" - peak in the middle and symmetric peaks in the tails. That would be 6th moment. I don't know if it has a name.

If you just look at plain old SPX vol by decade, it is actually going up. For monthly returns, I get:

1950 12.04%
1960 12.20%
1970 15.71%
1980 16.67%
1990 13.29%
2000 16.30%
2010 11.94%

The exception was 1990s, but arguably that is because the 1990s crash happened in 2001. The current decade hasn't had its crash yet.


"People say nothing's impossible, but I do nothing every day" --Winnie The Pooh

AndyM


Total Posts: 2319
Joined: Mar 2004
 
Posted: 2017-08-28 18:24
To ES's points, I don't think this sort of thing is naturally amenable to statistical analysis, given that systemic crises don't come along too often.

I used to be disgusted; now I try to be amused...

deeds


Total Posts: 348
Joined: Dec 2008
 
Posted: 2017-08-28 20:26
Ronin - what about "stiglitz" measures of risk?

...they seem to focus specifically on 'spread' in the sense you describe

ronin


Total Posts: 216
Joined: May 2006
 
Posted: 2017-08-29 16:58
Just looking at this data some more. This is 1y standard deviation of adjusted daily returns of SPX, based on data from yahoo finance.



Some thoughts:

(i) single digit vol doesn't seem to be all that special. It was in single digits throughout the 50s and 60s. In fact throughout 1964/65, 1y realised vol barely rose over 5.5%. There were no subsequent crashes when the time came to pay the piper - the first serious subsequent spike in vol was the 1970s oil crisis, and even then the vol barely went over 20%.

(ii) overvaluation of the SPX also doesn't seem to do it. SPX in 2000 was roughly the same as SPX in 2007. But the magnitude of the 2009 drop was a bit bigger than in 2001 (50% v 40%), and a bit faster (17 months from peak to trough vs 25 months). So the vol spike in 2009 was almost twice as high as in 2001, even though SPX was arguably more overvalued in 2001.

(iii) If anything, the 2001 crash was the textbook version of the "managed" crash that people here would clearly prefer - slow unwind, with vol a bit higher over a longer period of time, but never spiking. What went right in 2001, and wrong in 1988 / 2008?

Bottom line - if somebody showed me this as a justification for committing money to a trading strategy, I would say it doesn't convince me either way.


"People say nothing's impossible, but I do nothing every day" --Winnie The Pooh

iasmath


Total Posts: 43
Joined: Feb 2010
 
Posted: 2017-09-14 03:32
>> First question, what's up to cause all of this?
I'd say quantitative easing. The end of decent interest rates pushes money to risk...and selling vol/insurance becomes more appealing. All other aspects you mentioned are relevant too, but I think prices wouldn't be here if central bankers were not doing their crazy stuff. And FED statements are starting to recognize something on this direction, but still very shy.

>> Second question: Is this time different?
I don't think so. There is nothing new under the sun. We are running with spare tire. If/when growth turns down or something unexpected happen, we will have no support from central bankers. And there is always a game on leverage. 2008 banks/HFs were big. I think this time the leverage is on individuals through ETF's and other passive vehicles. The end of the game will be wild. But before we get there, go sell more vol...

"When we pull back the curtain, we see that the wizard is just a man, but also that the man is a wizard"

Osiris2


Total Posts: 4
Joined: Sep 2017
 
Posted: 2017-09-14 18:11
I'm biased, but I think credit is almost always the canary in the coal mine.
In round figures, it took about 10 years to build up the credit overhang conditions that led to '07-08 implosion, and roughly 10 years for the economy to work off that hangover through a combination of de-leveraging and low rates.
At this point, financial institutions and large pools of capital have more or less filled in the craters in their balance sheets and are ready to party.
One of the principal mechanisms that allowed this to happen was the effort by central banks to keep rates low (through both traditional monetary policy around the short rate and other things like QE and market ops.)
Look at how many big players are now shoveling money into various types of loans, looking to step down the credit curve without admitting that is what they are doing (hey we re-invented underwriting using 'big data' and 'AI' so it's all good!) It's like, when all the fools are dancing, the biggest fool is sitting down ... for those old enough to remember.

ronin


Total Posts: 216
Joined: May 2006
 
Posted: 2017-09-25 13:01
An interesting article on that topic in the WSJ.

WSJ - What We Know About Financial Bubbles

Apparently, a tech bubble leads to investment in new technology, which is overall good, and the subsequent fallout is contained - see 2001. On the other hand, a leveraged asset bubble where banks are significantly participating is bad - see 1988 and 2008.

"People say nothing's impossible, but I do nothing every day" --Winnie The Pooh
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