Markets Are Getting Jumpier and We Can’t Tell if That’s Good or Bad
“Those aren’t mountains… they’re waves,” says Matthew McConaughey’s character in the movie Interstellar, after the team of space explorers’ search for a new Earth-like world lands on an oceanic planet that is not quite as it seems. What at first appears to be a tranquil water planet, is rocked by a nightmarish tsunami before returning to its original, placid state.
2015 was a year of much market volatility. Except it also wasn’t. While the CBOE Volatility Index, Wall Street’s go-to measure for expected and actualized stock market volatility, increased compared to its 2014 average, it also remained stuck far below its longer-term averages. Meanwhile, 2015 was a year characterized by some wild days in both stock andbond markets.
A new note from Bank of America Merrill Lynch equity derivatives analysts led by Benjamin Bowler underscores the recent trend of relatively low market volatility on the whole, punctuated by brief yet violent bouts of market storms, so to speak.
Like the water planet, global markets now have an unnerving tendency to be hit by big isolated waves of volatility and then quickly settle back into their previously placid states. As the analysts note, “markets are setting records in terms of jumping from calm to stressed and back,” at the same time that the bank’s indicator of cross-asset market fragility is also rising.
In other words, where once we had fat tail risks we know have leaner tail risks that involve a single asset class being roiled whenever investors herded into similar positions, thanks to the crowding effect of central banks, decide to exit en masse.
“The key theme introduced in our 2015 year ahead, Storms in a teacup as vol[atility] finally starts its turn, was that we would see more ‘local’ shocks or violent moves that were relatively short-lived, as trading liquidity (bank balance sheets and fickle high frequency capital) continue to create a toxic environment prone to tantrums,” write the BofAML analysts.
For regulators seeking to de-risk the banking system in the aftermath of the 2008 financial crisis, short periods of market volatility are likely to be viewed as a success story so long as they don’t cause wider systemic stress. In short, the global financial system may be more resilient as a whole but pockets of it are certainly more fragile, according to BofAML which argues that relatively low average volatility is hiding rising pockets of vulnerability. The bank’s proprietary “fragility measure,” which measures volatility in its Global Financial Stress Index, is near 80 percent of its 2008 peak.
The weirdness of market volatility may go some way towards explaining the poor performance of large investors this year, given that post-financial crisis regulatory reform has pushed risk away from banks and onto asset managers instead.
Like Goldilocks, hedge funds and other large professional “buy-side” investors appear to favor market volatility that is neither too low or too high, nor prone to odd peaks and troughs. “Asset managers are struggling, with the poorest hedge fund performance relative to the risk they are taking since 2008, despite overall market volatility being only one-fourth of 2008 levels. Their poor performance is better explained by the extreme levels of market fragility,” BofAML concludes.