Markets Are Getting Jumpier, and We Can't Tell if That's Good or Bad

From calm to stressed and back.

Where Should You Invest in 2016?

"Those aren't mountains, they're waves," says Matthew McConaughey's character in the movie Interstellar, after the team of space explorers' search for an earth-like world takes them to an oceanic planet that is not quite as it seems. What appears to be a planet of tranquil waters turns out to be rocked by occasional tsunamis before returning to its earlier, placid state.

Source: Giphy

It is perhaps an (overwrought) metaphor for the current state of markets.

2015 was a year of much market volatility. Except it wasn't. While the CBOE Volatility Index, Wall Street's go-to measure for expected and realized stock market volatility, increased as compared with 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 and bond 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, violent bouts of market storms, so to speak.

Like the water planet, global markets now display an unnerving tendency to be hit by big isolated waves of volatility, then quickly settle back into serenity. As the analysts note, "markets are setting records in terms of jumping from calm to stressed and back" at exactly the same time that the bank's indicator of cross-asset market fragility has also been rising.

Source: BofAML

In other words, where once we had fat tail risks we now face leaner moves that involve a single asset class being roiled whenever investors who have been 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 drain risk from 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 masking more pockets of vulnerability. The bank's proprietary "fragility measure," which measures volatility in its Global Financial Stress Index, is at almost 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.

Source: BofAML

Like Goldilocks, hedge funds and other large professional "buy-side" investors appear to favor market volatility that is neither too low nor 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.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE