Market Paradigms Have Quickly Shifted on Investors
Two months after the meltdown of poorly designed exchange-traded volatility products became front-page news, the broader environment for market risk is in transition. Corporate profits and economic growth are strong, but there is unease about the future path of Federal Reserve interest-rate increases, the impact of rising fiscal debt and deficits, and the potential for trade wars. Realized volatility in the S&P 500 Index was 20 percent last quarter, up from just 6 percent in the fourth quarter. That is a tremendous increase.
Market participants are being forced to revisit the challenges that come when the regime governing risk is in flux, a process that has led to considerable disruption in past cycles. An appreciation of these dynamics, especially with the recent reminder of how derivative products can amplify risk, is in order. Investor psychology and portfolio rebalancing are important considerations when markets experience such a large shift in risk paradigms.
From an investor-psychology standpoint, both recency bias and narrative fallacy affect the ability to appreciate these transitions and complicate the process of adjusting portfolio exposures given higher levels of volatility. Investors give too much importance to market conditions that have most recently been in place. This bias gave rise to strong expectations that the extremely low level of volatility experienced last year would persist.
The consistency with which stock returns were positive in 2017 also encouraged a second behavioral shortcoming: narrative fallacy. Here, the market's need to carefully link cause and effect led many investors to conclude that the Trump administration's chaotic style had no implications for asset prices and risk. For example, in April 2017, President Donald Trump said: "There is a chance that we could end up having a major, major conflict with North Korea. Absolutely." The impact? The CBOE Volatility Index, or VIX, "spiked" to 10.8 from 10.3 and the S&P 500 barely budged. This lukewarm reaction -- a hallmark of last year -- fueled a narrative that the market was indifferent to the unpredictability of the White House. We're now learning otherwise.
Because these biases encourage investors to look backward, not forward, they make a shift to defensive strategies a difficult undertaking. Investors for whom a VIX below 10 became the new normal are looking at materially greater hedging costs and dissuaded from action because of the anchoring to a prior, much lower level of option pricing.
Another factor that makes transition especially fraught is that portfolio-sizing within the money management industry is highly pro-cyclical. When the level of experienced volatility is consistently low, investors feel competitive pressure to utilize leverage, sell optionality, or take illiquidity risk in order to achieve their nominal return targets. Many strategies are, in fact, specifically codified to use gearing when the recent level of realized volatility is below a set target. These include volatility control strategies that, while not all the same, generally deleverage exposures when realized volatility rises. While global economic growth has not been this well-synchronized in more than a decade, there is little doubt the U.S. has a unique ability to export asset price volatility to the rest of the world.
Financial cycles that have been as long and successful as this one tend to force the hand of even the skeptics. It is difficult to find an environment in which risk-taking was more pro-cyclical than the recent one, where the combination of low realized volatility, low interest rates, few debt defaults and strong corporate profits joyfully intersected. What's left at the end of so tranquil a period may be a unique fragility that results from asset prices themselves.
The late, well-regarded Massachusetts Institute of Technology economist Rudiger Dornbusch once said, “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.” As we observe the 10-year anniversary of the collapse of Bear Stearns, and with a fresh appreciation for the amplification of volatility that can come from financial products, investors ought to be actively considering various risk scenarios and the implications for their portfolios.
Option prices are certainly expensive relative to the calm of 2017, but in the context of the substantial daily gyrations in markets and the challenges inherent in adjusting to a higher-volatility regime, they can play an effective role in mitigating portfolio risk.
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