Back in December, BofAML noted that in a world where vol. spikes (and hence SPX dips) mean revert with remarkable rapidity thanks to the deeply-ingrained propensity of investors to view fleeting risk-off episodes as the only “alpha” opportunities (and yes, that’s a misnomer on purpose) against a backdrop where benchmarks only rise, investors “no longer fear shocks, but love them.”
The increasing rapidity with which intermittent flareups collapse has been a defining feature of markets over the past couple of years and this dynamic has become especially prevalent since Brexit.
Part and parcel of that dynamic is the idea that the central bank put has become self-sustaining – it runs on autopilot. Why wait on dovish forward guidance (or any other signal from the monetary gods) to buy the dip when you know with absolute certainty that in the unlikely event a drawdown proves to be some semblance of sustainable, policymakers will calm markets? If you know it’s coming, well then you should buy the dip now. This becomes a recursive exercise as everyone tries to frontrun everyone else and before you know it, dips and vol. spikes are mean reverting at a record pace as the prevailing dynamic optimizes around itself.
In the piece linked above, we specifically identified short vol. ETPs as a source of both local stability and fragility. We quoted Deutsche Bank as follows:
Shares outstanding in the short vol ETPs tend to increase following a volatility spike as investors rush to capitalize on the increase in vol. An initial spike in volatility will see short vol traders reengage and unless the vol spike ‘sticks’ we can expect the old behavior to continue.
Of course vol. spikes cannot “stick.” Because again, the interaction between the BTFD mentality and the central bank “put” that makes that mentality a (virtually) infallible “strategy” serves to optimize around the prevailing dynamic making change all but impossible.
Here’s what else we said in that same post dated December 6:
That said, the technical risk inherent in the VIX ETP rebalance (vega-to-buy on an N-vol. spike) and the possibility of that rebalance exacerbating the initial spike and forcing an unwind in vol.-sensitive systematic strats means that an inherent instability lies seething beneath an outwardly stable situation. It’s Kocic’s “metastability.” At heart, it’s fragility.
Indeed. And dammit, the chickens came home to roost earlier this month when the rebalance risk mentioned above (and detailed here on countless occasions in our “doom loop” section), catalyzed the most dramatic VIX spike in history as the short vol. trade blew up in spectacular fashion after sowing the seeds of its own demise for years.
Well nearly three months ago, BofAML illustrated the “fragility” of markets with the following chart:
In a new note, the bank has updated that visual and guess what? This:
Here’s the accompanying color:
Since 2014, we’ve seen a significant uptick in “fragility events” due to a host of factors impacting markets in the central bank dominated era. The most recent spike in equity vol was by far the most notable fragility event we’ve ever experienced as the ratio of peak vol reached in the spike over the total volatility generated by the event (defined in the footnote below Chart 17) was 9.3. This was nearly double the previous record of 5.1 set on 12-Sep-2016 when vol picked up on concerns over rate hikes.
As the bank goes on to note, “the early Feb vol shock was among the largest in history as measured by the sudden change in realized volatility where specifically, S&P 500 realized vol (EWMA version) increased 129% in the 5 days-ended 8-Feb-2018, the largest 5- day percent pickup since Oct-1987.”
And they’re not done. Just to drive the point home, BofA’s derivatives team spells out what’s annotated in the chart. To wit:
In fact, this metric has only increased a greater amount in a 5- day span three other times in history: in the Oct-1987 Black Monday crash, in May-1940 during the German blitz at the beginning of WW2, and in May-1948 when Israel declared its independence (notably, the rapid change vol in 1948 was fueled more by the equity market rebound than by the selloff).
Ultimately, I suppose you can take comfort in the speed of the mean reversion if you like, but I’m not sure increasingly fragile markets are something that’s desirable even if part and parcel of that fragility are V-shaped recoveries.
As BofAML notes right off the bat in the same piece excerpted above, some folks are concerned that last week’s exuberance notwithstanding, “a rapid V-shaped recovery and return to ‘pre-shock normal’ may not be a given.”