If anyone can bring metaphor and illustration to the market in volatility, it’s Chris Cole at Artemis Captial Management, a volatility-focused investment firm.
Take the intro of his latest note as an example:
Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation.Cole has been arguing for a while that the injection of huge amounts of QE-money into the system — the equivalent of a giant put option – has undoubtedly had an impact on volatility markets, and most likely in ways we don’t really understand. Yet.
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Today the existential fear of world’s end deflation is so powerful investors are willing to pay the highest prices for portfolio insurance in nearly two decades. The market for forward volatility has become unhinged as the SPX variance and VIX futures curves sustain historically high premiums over low spot vol.
My argument is not that this extreme fear is misplaced but that it is mispriced.
Like Odysseus in the epic poem the global economy is trapped between the monsters of Scylla and Charybdis. We risk one to avoid the other. From one world’s end to the next sometimes I wonder if decades from now we will look back with the hindsight that we were all hedging the wrong tail.
For one thing, Cole observes that since early 2009 volatility spikes have consistently occurred shortly after the end of central bank balance sheet expansion. “The greater the level of monetary expansion the calmer the Vix and the higher the gains in the S&P 500 index (and vice versa). Volatility markets know this and that game theory expectation has contributed to the steepest SPX volatility curves in over two decades.”
Note the following chart to observe the shift in the volatility curves:
What’s more, there’s even been a correlation between central bank balance sheet expansion and short interest build-up in the VXX, one of the most popular Vix-linked exchange traded notes, observes Cole:
Short interest levels on VXX typically climb during Fed balance sheet expansion and continue to do so well after the printing ends until the inevitable VIX spike causes rapid short covering. The dynamic was most evident during the 2011 summer correction when VXX short interest tracked with Fed balance sheet expansion through April and continued to climb all the way until the VIX hit 43 in August. During VIX spikes in both May 2010 and August 2011 traders shorting the VXX overstayed their welcome at the stimulus punchbowl failing to recognize the Fed had left the party and the reality police were knocking on the door.
So where does this leave us?
According to Cole the world is now in the
midst of a new volatility regime, a regime that’s defined by investors’
willingness to pay almost anything to shield themselves and their
portfolios from the next deflationary apocalypse. All of which is
translating to abnormally steep volatility curves, overpriced tail risk,
high implied volatility of volatility, and underperformance of
portfolio insurance.
Investors are consequently losing sight of what might really be considered a black swan event.
As he notes:
Tail risk insurance is at the most expensive relative levels in over two decades of data reflecting a profound emotional fear of deflationary collapse.
Tail risk bets protecting against extreme declines in equity markets are now priced at multiple times the eight decade historical probability of those declines being realized (we can never know for certain true future probability). The evolution of portfolio insurance premium is observable via the implied probability distributions for returns backed-out from S&P 500 index options.
Tail-events are effecively being priced as
if they were standard risks. That means you get much better pricing
today hedging smaller declines of higher probablity rather than very
rare but extreme crashes, says Cole.
Which means one of two things. The chances
of another deflationary crash are really much more probable than
before, or deflationary fear is hugely mispriced in the market.
Inflationary fear, on the other hand, is massively underpriced.
And none of that changes the fact, says
Cole, that when a crash does happen and all these buyers look to cash in
on their expensive tail risk insurance, the jackpot will have become a
lot smaller.
“All that expensive protection will likely underperform expectations and in the end you would have done better hedging closer to the odds. It is hard to make money knowing what everyone else already knows.”Maybe the market is correct in buying tail risk insurance … but everyone is just hedging the wrong tail.
That’s to say: Don’t be fearful of a crash. Rather, be fearful of not participating in a mega rally.
But don’t label Cole a paranoid
inflationista. He isn’t coming to that conclusion because he’s obsessed
with money debasement and the hoarding of gold bullion. His conclusion
is based on the market’s own pricing of inflation risk.
Hyperinflation is now the outlier — and as a result it’s very cheap to protect against it in volatility markets.
His conclusion:
I can’t tell you if hyperinflation will ever occur but what I do know is that the single most undervalued asset class to hedge against this rare event is volatility itself. As institutional and retail investors herd into commodities, farmland, and gold they ignore the powerful leverage afforded to them using extremely long-dated call options and model-free variance.
Something for the goldbugs to chew on, at the very least.
For more of his thinking check out the full note in the Long Room.
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