Last year was unusual in many respects for financial markets. When expectations for how events normally unfold become challenged by data way outside its normal range, it is easy to imagine the world has gone mad.
A science-fiction genre exists where the protagonists have jumped to (or awoken in) an alternative world. Think “The Man in the High Castle”, the “Star Trek” episode “Mirror, Mirror” and “It Can’t Happen Here”.
To this group, you can add a new title: “Outlier 2017.” I can imagine the sonorous baritone voice-over during the opening scene: “It was a year filled with aberrations.” To wit:
* Above average US market returns;
* Record corporate profits;
* Even higher returns overseas, especially for US investors when priced in dollars;
* Record low market volatility;
* Record high political volatility;
* Fed funds rates near record lows;
* Market interest rates near record lows;
* Below normal inflation;
* Low bond yields.
But those unusual data points are ephemeral, as statistical outliers always revert to historical means — eventually. And so that is what we are living through this year. Indeed, if 2017 was a year of eccentricity, then 2018 represents a return to normality.
What has changed? Combine above average returns, the passage of time and a very specific technical event and you create the right environment for reversion. The US equity markets have risen for nine consecutive years, and during seven of those nine years, it rose by double-digit amounts.
It is easy to see markets getting a little ahead of themselves, and needing to digest those gains. Those who look at the longer market cycle after this fantastic run wouldn’t call a quarter or three of sideways action unexpected.
Why did volatility suddenly return? Consider that long run of gains by the broad indexes. Active traders and hedge funds found a profitable trade in making highly leveraged bets against volatility.
Of the dozen or so exchange-traded funds and exchange-traded notes designed to make this bet, much of the capital was concentrated in just a few of them. The precise factor that precipitated the blow up of these products is unknown.
My best guess is that someone somewhere back in February decided enough was enough — it was time to take their chips off the table. For some historical perspective, let’s look back to December 2006, when the VIX, which is sometimes referred to as the market’s fear index, hit a cyclical low of 9.39, just as the housing market began to stumble and stock markets were beginning their final run up ahead of the Great Recession and a subsequent 57 per cent crash.
For anyone looking for a technical signal that the moment had come to unwind a levered VIX trade, that time was as good a time as any.
As the VIX was getting closer to its record low of 8.56 in November 2017, my guess is a chain of events led large holders of the leveraged volatility notes to start cashing out. A trickle at first, then a flood.
As so often happens, selling begat more selling, especially with this highly leveraged trade. Pretty soon, a vicious volatility cycle was underway. It wasn’t an outright panic, but rather, gradual selling that fed on itself, playing out over a few months, from November to February, when the VIX spiked to 50.3.
Why would selling volatility notes cause volatility to rise? There is an adage on Wall Street that goes, “When you are under pressure, you don’t get to sell what you want, you sell what you can.”
Meaning, whatever is liquid and easily converted into cash gets sold, often to meet margin calls. Anecdotally, some traders owned S&P500 ETFs market indexes as the underlying collateral for volatility notes purchased on margin.
As volatility spiked, the value of the notes exceeded its value underlying the margin. When the trade began to get squirrelly, someone needed to raise cash, and fast. This could explain why markets took a hit in response to a rise in volatility.
This is only theory, a surmise barely disguised as a guess. But it’s as good an explanation as any I have seen anywhere else.
The return of volatility changed the tone of the market. The reaction to various tweets by President Donald Trump was very different, even if Trump’s rhetoric was the same as last year.
So why did traders respond to things in 2018 that they ignored in 2017? Your guess is as good as mine.
I have said before that presidents get too much credit for market rallies, and too much blame for their crashes. The “Trump slump” narrative is every bit as invalid as the “Trump bump” heard so often last year. But today, the world sees thing differently.
