Heisenberg Report

Here’s How You Will Know If Another Black Monday Is Coming…

As detailed earlier this morning, the enterprising among you are searching for “triggers” – canaries in the coal mine, as it were.

But that’s just the enterprising among you. Most of you have convinced yourself that there is no need to seek out the boy in the crowd who will break the spell by insisting the emperor has no clothes. That’s a thankless task in a world where doing the “right” thing and rebelling against the prevailing dynamic is akin to heresy and will invariably result in foregone carry and underperformance which, if it persists long enough, will bankrupt you.

On top of that, searching for triggers may be more than thankless – it may be futile. Because as Citi recently put it, “triggers are often latent – the long-term problem is obvious, but it is ignored until suddenly it explodes without much warning.”


But according to BofAML, history suggests we will receive a warning and it will come in the form of vol. rising between 10% and 20% between 50 and 75 days prior to the meltdown.

When the bank looked at S&P realized volatility in bull and bear markets dating back to 1928, they found that “apart from four outlier bear markets (the Great depression in 1929, GFC in 2008, the ’87 crash, and LTCM in 1998), the volatility in the previous bull market is highly explanatory of the subsequent bear market vol.”:

The implication there is that as long as we don’t witness a shock of the 1929, 1987, or 2008 variety, vol. during the next bear market would average 18%.

The obvious question is this: ok, but what if the next bear market isn’t “normal?” Or, put differently, what if it emanates from a systemic shock or a liquidity crunch? Well, BofAML’s derivatives team doesn’t think the former is particularly likely. “Given the significant regulatory response to the GFC, bank deleveraging, and risk transfer to central banks who are relatively mark-to-market insensitive, the risk of a GFC repeat seems contained.”

As far a ’87 or an LTCM-type crisis is concerned, the bank suggests that the writing would indeed be on the wall at least a month prior. To wit:

While we believe the underlying conditions to create a similar shock to 1987 or LTCM may not exist today, history shows a shock of this magnitude has never occurred from the current level of vol. In other words, we should see a forewarning in rising vol before events of these magnitudes.

Interestingly, the behavior of vol leading into both ’87 and LTCM is remarkably similar (Chart 11), with S&P realized vol rising from 10% to 20% between 25 and 75 trading days prior to the shock. Also, vol fell back to 20% in both cases between 50 and 75 days following.

Of course given the buildup of technical risk in the form of VIX ETPs and vol.-sensitive systematic strats, the very fact that vol. is rising could itself tip the first domino, and while BofAML thinks the risk of that may be exaggerated, it’s worth noting all the same.