We (and others) have talked a lot lately about mean reversion.
More specifically, there’s been quite a bit of discussion about the rapidity with which volatility shocks are quickly “arbed” (and we use that only half-jokingly) away by the overwhelming tendency of traders and investors to BTFD.
As BofAML recently noted, the whole idea behind BTFD is now in question, as central banks look set to (try) and remove the $400 billion/quarter liquidity flow training wheels. Here’s what BofAML said earlier this month:
Perversely, US equity sell-offs have seemingly become embraced as alpha (i.e., buy-the-dip) opportunities instead of being feared as bona fide risk-off events, as the central bank put has become a self-fulfilling prophecy. The abnormality of this development is best appreciated through the lens of market volatility, in our view. Chart 9 shows that the speed with which S&P volatility collapses from a state of high stress back to calm has been escalating since the Aug-15 shock, culminating in unprecedented mean reversion during the 2016 US Presidential election.
The BTFD chatter was readily apparent on Tuesday – and with good reason. If yields and the dollar were any indication, Monday probably should have turned into the bloodbath it looked like it would be at the open. But it didn’t. Guess why? Recall the following from SocGen this morning…
Equity market participants have taken a look at the lower yields and weaker dollar and decided that since absurdly low rates are the elixir that the equity bull market lives on, they might as well ‘buy the dip’ yet again.
Well, in light of all this, and (again) in light of the fact that one way or another (and albeit very gradually) the central bank backstop is set to fade away, you might find the following from SocGen to be particularly interesting.
Whether quantitative easing (QE) worked used to be a moot point. The ECB president holds a sanguine view of this. As he put it in his latest press conference, “the pass-through of our monetary policy measures is supporting domestic demand and facilitates the ongoing deleveraging process”. For investors, QE brought substantial capital gains in risky assets and long-dated debt. But unconventional monetary policy cuts both ways. In the face of lofty valuations and low interest rates, investors have increasingly looked for alternative sources of returns elsewhere.
Trend systems benefited greatly from the US dollar rally in 2014, high-quality shares outperformed in 2015, and the volatility premium took off in 2016. However, with investors chasing any alternative opportunity, returns eventually leveled out.
As long as central banks were pulling the strings, there was something obvious to do. Buying shares any time they went down was a simple way to benefit from the ‘Yellen put’. This approach was challenged during the China shock, but even there, central banks did not disappoint.
With the prospect of higher rates weighing on risky assets, there may even have been something like a ‘Yellen call’. The investor who bought the market when the price went down and sold when the price went up pocketed a hefty premium. Meanwhile, a combination of the two main equity factors, value and quality, struggled to beat the market.
Just as the Federal Reserve is finally taking the plunge, and as a new wave of politicians in the US and Europe look bent on redefining anything from haircuts and dress codes to the pillars of the Western liberal order, any talk of ‘mean reversion’ seems a bit out of sync.
That’s followed by a big “however” and a whole bunch of complementary analysis and color, but the point here is simply this: BTFD has been enshrined in the market’s collective consciousness for nearly a decade. What happens when the “reason for the season” – so to speak – disappears?
[Note: in the second chart, the mean reversion (the blue line) is the SGI US Gravity Index defined as follows: “US equity markets appear to have a tendency to mean revert, meaning that large positive moves are often followed by negative ones (and vice versa). On average, this should result in a positive spread between the daily and bi-weekly realized variance of the returns of such markets. The SGI US Gravity Index is a systematic index with its level published daily on Bloomberg, aiming to generate positive performance by capturing this spread on the S&P 500 Index.”]