A week ago, there were wobbles. Trump impeachment! Brazil impeachment! Here it comes! Risky assets correcting! Finally! There has been a bizarre desperation for a downturn in order to feel more invested in the upturn. The truth is, we feel uncomfortable. We know the underlying drivers are changing: central banks are trying to turn off the liquidity taps; wages aren’t going up enough to suggest lower unemployment will translate into growth; and the new actors on the stage, the politicians, are unpredictable. So why does “Buy The Dip” win every time?
It’s not just a funny feeling in our stomachs. Here’s a chart from BAML on how quickly drawdowns bounce back:
The fact is, cheap money is still sloshing around, and that money has to be put to work. But that doesn’t get to the heart of why recent history appears so markedly on this chart. BAML have looked at “5 sigma” drawdowns. That’s 5 standard deviations; in physics, it’s being 99.9999% confident of an outcome, or of it happening only once every 3.5million years. In other words, it’s a drawdown of a magnitude that doesn’t happen very much. Something akin to a crash. (Note the first bar on the chart is October 1929). But the drop in the S&P last week didn’t feel like a full on crash, did it? That’s because the standard deviation is measured on recent history: if things haven’t moved around much, then it only takes a small move to feel quite significant.
So the real reason that recent history appears on this 5 sigma chart is because volatility is so low. And when it moves, it doesn’t move for long. So the volatility OF volatility is also very low. Volatility eats itself. We first flagged this in the summer of 2014, which marked the absolute lows in cross asset volatility. But since then the impulse has proliferated. In September 2015, we noted ‘All of these bets to protect oneself against volatility are in fact causing volatility’. The flash crashes started, from the biggest drop in the NZD for 30 years to US Treasury yields. They were tremors. It took new foundations for our economies to shake them out further, with the introduction of political risk. GBP/USD hit 1.5000 the night of the Brexit vote; 24 hours later it was 1.3500, and then 4 months later, 1.1800. But then political risk was assimilated by the vol-eating machine. It learned. The impact of Trump’s election on risky assets was just a few hours; by the Italy referendum it was minutes; by the French election, it was ahead of the event itself.
Buy the dip is becoming a monster. It started as a mandated policy from central banks to drive animal spirits out of their “sell everything” funk. It took over as economies genuinely recovered. But then the proliferation of ultra-liquid ETF trading, plus the assimilation of volatility itself as an asset to be traded, created a self-reinforcing cycle. Active fund management lost out: more money flowed into passive. Buy risky assets, but buy VIX ETFs: a portfolio protected against tail risk, and cheap at the price! The more VIX buying, the more vol-selling strategies succeeded. And so on, and so on.
When will it stop?
Well, things are still only at the edge of insanity. Here’s BAML with another chart, this time of how “high yield” credit now yields less than plain old equities:
Of course, this has been twisted by the QE implemented by the ECB and the BOJ. Unlike the Fed QE these guys are deliberately buying up corporate debt, just as it’s become even harder to source, due to the regulatory reduction in banks holding this to warehouse risk. Yes, we can throw regulatory change into the new market structure too. It’s all allowing the persistent passive money to become a dominating force in driving the market.
You think it’s insane now? Well Robert Shiller, he of irrational exuberance fame, just came out with the line of staying in the market because it ‘could go up 50% from here’. He does go on, “But I think if one wants to diversify, US is high in its CAPE ratio. You can go practically anywhere else in the world and it’s lower”, suggesting that maybe the S&P500 might not be the best place to Buy The Dip (or at least, Buy Less Than Elsewhere On The Dip).
This will all only crack when economic growth genuinely stalls, or when political risk becomes taken more seriously. To break the quant driven market, where we talk in terms of 5 sigmas, we need to become aware of the unquantifiable. Be ready for volatility to suffer some serious indigestion. But in the meantime, yes, BTFD…