by Doug Kass, Seabreeze Partners Management
I have argued that risk is under-priced because in large measure of the structural changes in the markets and participants positioning.
Risk is an ever-present condition that cannot be eliminated, though it can be shifted through time and redistributed in form.
In today’s market many believe that they have achieved protection over risk, but they actually are becoming its servant.
And when investors and quant strategies such as risk parity and volatility trending are all increasingly on the same side of the volatility boat, the odds favor that the boat likely will tip over.
Black Monday — Oct. 19, 1987 — came out of nowhere. The Indices were in a bull market and many saw no reason for a decline. At that time (and on that day), the markets lost more than 20% of its value as volatility advanced to an all-time high of 150 based on the VXO index, which preceded the VIX index.
It was caused by a broad adoption of portfolio insurance and represented the first modern-era crash that was driven by machine feedback loops.
It won’t be the last.
A longtime acquaintance of mine provided these thoughts after attending the recent Grant’s Interest Rate Conference. His concerns should be familiar, as they echo mine that have been voluminously mentioned in my Diary over the last two years:
I have made the point many times over the last several years that I thought the structure of the market was such that it couldn’t really decline, it could only crash. In the last year or so I have been able to put some meat on the bones of that idea based on data from various people. After the recent Grant’s Conference, I shared the thoughts from one of the speakers who had tallied up the data to show that there are various strategies that mimic portfolio insurance and were sizable enough to create a similar outcome.
Cole’s paper goes into detail about that, and other factors, and I think that anyone who has any exposure to the market — either by having money in it or because you participate in our economy (which is to say, everyone) — needs to understand the points made in this report. Just to share a few thoughts to wet your whistle, he notes that what we have been seeing lately has created a situation whereby, “Responsible investors are driven out of business by reckless actors. In effect, the entire market converges to what professional option traders call a ‘naked short straddle…a structure dangerously exposed to fragility.” He then adds, “Volatility is now the only undervalued asset class in the world.”
The Price for Business As Usual: Cole goes on to describe the “global short volatility trade” as, “any strategy that derives small incremental gains on the assumption of stability in exchange for substantial loss in the event of change.” One of the perverse reasons why a strategy as destined to fail as this is continues is because it can work longer than one would think that it should, and then participants pile in thinking that the naysayers are delusional. Cole adds,
“Many investors, and even practitioners, are ignorant or in denial that they are holding a synthetic short option in their portfolio. In current markets, there is an estimated $1.12 to $1.42 trillion in implicit short volatility exposure…”
He then describes what happens to folks who are in this boat where they all happen to be “short gamma.”
“When large numbers of market participants are short gamma, implicitly or explicitly, the effect can reinforce price direction into periods of high turbulence.”