We’ve mentioned this before, but on Friday evening it’s time to mention it again.
When it comes to sellside research, there is Deutsche Bank’s Aleksandar Kocic and then there is everybody else.
It’s been readily apparent for at least a couple of years now that when it comes to creative writing skills and the ability to analyze markets using innovative frameworks, Kocic is head and shoulders above the rest of the Street.
Here recently however, the quality gap between Kocic’s notes and those produced by his peers has begun to approximate something like the skills gap between Michael Jordan and the rest of the NBA. That is, it no longer makes much sense to draw comparisons.
That makes introducing his pieces exceedingly difficult. Allow me to explain.
Kocic’s latest, for instance, is about complacency in markets. A well-worn topic. Indeed, the entire world is talking about the low vol. regime, the carry trades it’s supporting, how central banks are enablers, and how market-based measures of uncertainty have become completely detached from geopolitical/policy reality. Throw in a dash of gamma, a reference to VIX ETP rebalancing, and maybe top it off by mentioning CTA deleveraging and just like that, you’re part of the conversation.
So you would think introducing yet another piece about all of these same topics would be as simple as noting the ubiquity of the subject matter and then providing a little context in the form of a reference or a handy name drop. One might start off with something like this, for example: “Echoing the sentiments expressed last week by JPMorgan’s Marko Kolanovic,” or “expanding a bit on the work of Kocic’s colleague Rocky Fishman,” etc. etc.
But see that doesn’t work with Kocic’s notes anymore. Because they’ve become so much better than quite literally everything else produced by the rest of the Street that they elude comparisons. Kocic is not “echoing” anyone but Kocic. He is not “expanding” on anyone else’s work as much as he is summarily antiquating it with an overwhelming dose of genius.
You can read Kocic’s latest below and really, you’re probably going to need to read it three times. Once to get the gist of it. A second time to fully appreciate it. And then a third time to chuckle at the thought of how thoroughly discouraged every other analyst who thought they were going to write something about volatility this weekend is going to be when they try to figure out how to top this…
Via Deutsche Bank
Complacency refers to uncritical satisfaction with oneself or with the position at which one is (it derives from the Latin word complacere, “to please”). Complacency generally carries a negative connotation — there is something narcissistic about it. It implies unhealthy inward-looking perspective: One imagines of being in a better position than he really is, missing an opportunity to improve. When used in the market context complacency implies a state of comfort that is out of sync with perceived levels of risk. It is almost always identified with shortsightedness, a mistake associated with overlooking the longterm consequences. In the same way a boxer who drops his guard runs a risk of being knocked out, complacent markets are facing a potentially painful encounter with reality.
Can market complacency be quantified?
Complacency is a conditional category. In some sense, it reflects the absence of risk aversion, although not only that – it is almost synonymous to taking an unhealthy amount of risk. But unhealthy relative to what? In the same way risk aversion requires comparison of two independent measures of risk, complacency is defined relative to a perceived level of (unrealized) risk.
Consider a coin toss as an example. The physical probability between heads and tails is 50/50. However, any bets that involve coin toss as a decision instrument will always overweight probabilities of unfavorable outcomes. For example, if the payout of the gamble is $10 for the heads and $0 for the tails, no one would pay $5 (the expected value = 50% * $10 + 50%* $0) to play, but less than that, say $4. So, the actual price is evaluated as an expected value with 60/40 probability assignment (40%*$10 +60%*$0 = $4). This is the essence of risk aversion. Because the actual risk involved in a coin toss can be accurately determined, reweighting of probabilities which incorporate risk preferences can be measured precisely and quantified. The price of risk aversion is $1, the risk premium that is the difference between the expected price of $5 and the $4 at which it is traded.
We approach the problem of quantifying complacency in the same way as we did for the risk premium in the coin toss example by comparing the two different measures of economic uncertainties: Economic policy uncertainty index and VIX (implied S&P volatility).
Economic Policy Uncertainty index (EPU) was proposed last year by Baker, Bloom, and Davis (Quarterly Journal of Economics, 1593, (2016) Vol. 131) and has been since implemented both as global and the US in various forms (Bloomberg ticker: EPUCGLCP Index). In our analysis, we choose the global EPU; use of other indices lead to the same qualitative conclusions.
The index is constructed by counting the frequency of articles in ten leading US newspapers that contain three of the target terms: economy, uncertainty; and one or more of Congress, deficit, Federal Reserve, legislation, regulation or White House. These numbers are properly normalized by their means and standard deviations of occurrence and combined into an aggregate index (see p. 1599 of the article for details). As such, EPU is completely market independent (in the same way the mechanics of a coin toss is relative to any particular gamble).
As an alternative measure of risk, one that reflects the market prices, we choose equity volatility. Similar, although noisier, results follow for almost any other market implied volatility (e.g. rates or FX). The history of the two measures of uncertainty is shown in the Figure.
Until 2012, for the most part (but not always) both levels and spikes tend to be coordinated across two measures. When VIX is in tune with EPU, the market is acknowledging the levels of risk through the prices. When VIX is low and EPU high, markets are complacent – they are underpricing risk. Spikes across different events are summarized in the Table (chronologically, from left to right). After 2011, the two measures of risk decouple with VIX consistently low despite growing uncertainty. The breakdown is structural, and it is visible across all market sectors, not only equities.
In order to quantify market complacency, we compare the two measures in the following way. We regress EPU onto VIX until 2011 und treat the residuals as the measure of complacency. The two Figures show the EPU index overlaid with the regression scaled VIX and the residuals.
In this measure, it appears that the markets have made a structural shift towards higher levels of complacency in the last six years. Current levels of complacency are alarming. This is what everyone is talking about. Despite growing uncertainties and tensions, the market volatility refuses to rise. Persistence of low volatility is increasing the penalty for potential dissent and reinforces one sided positioning. As a consequence, the risk of disorderly unwind is growing. And the longer this regime continues, the lower the threshold of painful unwind. Currently, VIX at 15% is perceived as a problem although before the crises it had traded above 20% most of the time. Similar observations hold for rates gamma, currently around 60bp, compared to pre-crisis averages around 100bp. It appears as if the markets lost their capacity to deal with uncertainty? So, have the markets changed, or was it actual uncertainty that is different now? Is it our risk appetites or the “coin” that are different?
The decoupling: Abnormalization of market volatility and turbocomplacency
The 2008 financial crisis represents a turning point in the way the markets have been pricing risk aversion, for the simple reason that during that episode the tail risk had been realized.
As a consequence, fear has gotten a new dimension. In the past, fear has always been treated as a sign of incompleteness, something one has to outgrow. After the crisis, fear has emerged as a new cognitive principle. And, as much as the Central Banks have tried (and succeeded) to reduce volatility, they did so by growing their balance sheet and, in that process, raised some red flags — after all, it was the excessive leverage of the households and banks balance sheet that led to the financial crisis. The warning sign about the tail risk became louder, so much so that tail risk became a buzz word of the second decade.
While Central Banks reassured the markets of their intent to do whatever it takes to support risk assets, their balance sheet growth and risk of future unwind remained persistent topic in media. They were perceived as a source of (latent) systemic risk; everyone wanted to play in that space and the street was eager to source it. At the same time, backed by the Central Banks’, risk assets became positively convex and continue to gain in value as well as their stability. The post-2012 rise in EPU and divergence from the declining VIX was the result of these developments.
Semiotic inflation: Informational overload and disappearance through proliferation
When it comes to complacency, the reference point analogous to the coin toss is not exact and not known ex-ante; it is based on perception not on actual levels of risk. In this way, complacency is an implicit judgment about the quality of information that reports the danger.
When information becomes a commodity, it takes very little time for it to lose its value. Unlike other (physical) commodities whose price is driven by diminishing supply, information markets are exact opposite — their essence is captured by diminishing demand. On one side, there is nothing to slow down its supply — it costs nothing to produce it. On the other, demand for information is biologically constrained by our capacity to absorb a limited amount of it. So, sooner or later, we have to reach a state of semiotic inflation where more information buys less meaning. The rate at which we reach this point depends only on the efficiency of the media. It is safe to say that in the last decade, especially the last five years, we have witnessed an accelerated approach to the state of super- fluid information flows.
This is when the positive feedback begins. When we operate under informational overload, we tend to defend ourselves by filtering excess information. It means that we are deliberately underplaying the importance of its content and implicitly questioning credibility of its sources. This can be perceived by those who observe us (our parents, guardians, parole officers, risk managers…) as troubling. And the more we ignore their warnings, the more they will be warning us. This is an example of disappearance due to proliferation: Filtering of the information forces its proliferation which is further ignored (we can’t absorb any more) and its production further reinforced until it is completely ignored and, therefore, invisible.
In our view, complacency and semiotic inflation have become two sides of the same coin. The abnormalization of market volatility is a function of both capitulation under informational overload and the moral hazard created by punitive costs of tail risk hedging in the carry trade environment. Nothing illustrates this better than the performance of the long (VXX) and short (XIV) VIX ETFs (Fig 16).