The Avalanche

People often use the “deer in headlights” phenomenon as an analogy for tumultuous markets.

That’s probably a misappropriation.

After all, a deer that’s caught in headlights is anything but erratic. It’s frozen. Unable to react or, more colloquially, unable to get the fuck out of the way.

Here’s David C. Yancy, a deer biologist with the Kentucky Department of Fish and Wildlife Resources to explain why this happens:

Deer are crepuscular. Their activity peaks within an hour or so on either side of sunrise and sunset, so their vision is optimized for very low light. When a headlight beam strikes eyes that are fully dilated to capture as much light as possible, deer cannot see at all, and they freeze until the eyes can adjust.

They don’t know what to do, so they do nothing.

Seen in that light (get it?), the current environment, characterized as it is by competing narratives, a manic news cycle, and a fraught geopolitical backdrop, has rendered markets incapable of knowing what to do. So, markets do nothing.

There are too many embedded contingencies in the narrative for market participants to make a truly informed decision. “So, what does one do when no decision can be made?,” Deutsche Bank’s Aleksandar Kocic asked last week. “Well, one waits.” Or, to couch it in deer terms, one “freezes until the eyes can adjust.”

Because the deer community has not, to date, developed a market that allows for the buying and selling of time spent staring into the grills of 4X4s, deer are unable to monetize that uncomfortable waiting period during which their eyes adjust to bright light. Traders, on the other hand, can indeed sell the “waiting time” that accompanies dissensus. Here’s Kocic (again from last week’s missive):

Volatility declines either when the markets are predictable or when there is no consensus. Dissensus has emerged as a new paradigm – an absolute inability to form consensus across variety of contexts, accompanied with an onset of a breakdown of conventional frames of reference. So, what does one do when no decision can be made? Well, one waits. As a consequence, the market flows are slowing down and vol sellers emerging.

That’s one kind of complacency – the kind that accompanies a complete lack of consensus.

The problem is that “complacency has moral hazard inscribed into it,” Kocic wrote in a new piece out Thursday. “It encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which further reinforces bad behavior,” he continues.

We, unlike the deer community, can get a positive carry by disposing of the time spent staring into headlights. We can, in Kocic’s words, “sell something [we] don’t want and get paid for it.”

Well on Saturday, we get an expanded version of Kocic’s Thursday note (the one we ran on Friday night). You’ll recall this passage:

Persistence of low volatility causes misallocation of capital. This is the main danger. For a given level of uncertainty, on the risk/reward curve investors settle at a point that corresponds to their risk limits. This position is determined by the cone on the risk frontier frontier, its width commensurate with volatility. As volatility declines, the cone shrinks and returns decline. This compels investors to move across the frontier towards higher risk in order to enjoy the same return.

Assuming you read last night’s post, you might have found that hard to visualize.

That’s no problem because in the expanded version, Kocic has drawn you two pictures. Here they are, matched up with their corresponding quotes from the excerpted passage above:

For a given level of uncertainty, on the risk/reward curve investors settle at a point that corresponds to their risk limits.

Kocic1

As volatility declines, the cone shrinks and returns decline. This compels investors to move across the frontier towards higher risk in order to enjoy the same return.

Kocic2

“Although volatility remains depressed, the risk continues to be pushed to the tails,” Kocic concludes, calling this “a buildup of metastablity,” and noting that “the longer the stick remains still, the more surely it will fall.”

Wait, what’s “metastability”?

And further, what “stick?” Who said anything about a “stick?”

Well, Aleksandar did – in the first paragraph of his latest, which I’ve just backed you right into using his previous notes, our own coverage of those notes, and a (correct) application of the deer analogy. How’s that for creative writing skills?

Via Deutsche Bank

Metastability

Big changes threaten to explode not when uncertainty begins to rise, but when it is withdrawn. Excessive determinism is almost always the biggest enemy of stability. This seeming contradiction is behind the concept of metastability which captures the mode of market functioning in the last years.

Imagine you have to balance a long stick on your finger. By placing it vertically on your fingertip, the stick could fall either left or right from its initial position because standing upright is unstable. However, in trying to keep the stick vertical, you instinctively (and randomly) wiggle your finger. The added randomness (noise) acts as a stabilizer of an otherwise unstable equilibrium. So long as the noise is administered carefully, the stick remains vertical, or metastable. The withdrawal of noise becomes destabilizing.

In general, there are three types of equilibria to distinguish: stable, unstable and metastable. The bottom of the valley is stable; top of the hill is unstable; a dimple at the top of the hill is metastable (Fig). Metastability is what seems stable, but is not — a stable waiting for something to happen. [An] avalanche is a good example of metastability to keep in mind — a totally innocuous event can trigger a cataclysmic event (e.g. a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche).

Kocic0

Complacency is a source of metastability. It has a moral hazard inscribed into it. Complacency encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which further reinforces bad behavior. This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems.

Complacency arises either when everyone agrees with everyone else or when no one agrees with anyone. In these situations, which capture the two modes of recent market trading, current and the QE period, the markets become calm and volatility selling and carry strategies define the trading landscape. But, calm makes us worry, and persistent worrying causes fear, and fear tends to be reinforcing.

One final note.

When you think about the avalanche bit, recall this chart from Kocic’s colleague Rocky Fishman:

DBVix1

That’s from April, so the thresholds have invariably changed, but the point is the same. Namely that the unusually low level of vol has brought the threshold beyond which massive ETP short covering would transpire down to a level that isn’t entirely far-fetched. As Fishman puts it, “low VIX futures levels make an N-point vol spike look like a huge percentage.”

To someone who doesn’t understand the dynamics at play, VIX at 20 might not seem like it should trigger a catastrophe. But no one who shouted something to their friend on a ski trip could have imagined that their scream would cause an avalanche either.

You have to understand how much risk has built up below the surface.

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