“But aren’t we more vulnerable now?,” Goldman asks, on your behalf, in a sweeping new note that finds the bank pondering the prospects for an outright bear market.
The bear market question is obviously front and center after an October that saw big-cap tech log its worst monthly performance since 2008. Global equities have been under pressure all year, but thanks to late-cycle stimulus, U.S. stocks have remained largely resilient.
That said, October marked the second correction in the short space of 10 months, and history shows that “typical” bear markets are preceded by a correction and a subsequent bounce, as investors initially buy the proverbial dip while waiting on “confirmation” (e.g., from the macro data) that something more sinister is amiss.
In the noted mentioned above, Goldman suggests that despite their Bull/Bear indicator being stuck at an (extremely) elevated 73%, the odds are probably still skewed in favor of a period of low returns as opposed to an outright bear market. They outline their rationale for that contention in detail and we summarized it on Saturday evening.
But the question of vulnerability posed here at the outset looms large. There are two main concerns, both of which have received lengthy treatment in these pages over the years. The first is the “ammo” problem and the second revolves around the perils inherent in modern market structure.
The “ammo” issue is pretty straightforward, although if you want to dive down the rabbit hole, you can via the post linked below. Developed market central banks would appear to be hamstrung in their capacity to respond to new crises by the fact that rates are still so low (negative in some locales) and balance sheets are still bloated. The Fed has made some progress in both regards, but generally speaking, monetary policy is still very, very loose, which means it’s not clear how policymakers would respond to a sharp downturn. In the U.S., the Trump administration’s decision to pile deficit-funded stimulus atop a late-cycle economy means American fiscal policy is also exhausted. In Europe, there’s considerably more room for fiscal policy to turn expansionary, which could help ameliorate a lack of flexibility from the ECB.
“The US has already expanded fiscal policy, and its debt levels and budget deficit are rising, which could make it difficult to find room for significant easing”, Goldman writes, adding that “there may be room for US interest rates to be cut in the next downturn but less so than in other downturns [and] European interest rates may still be at or close to zero when the next US downturn hits. The same would be true for Japan”.
So that’s the “ammo” discussion. On modern market structure, the story is always the same. The current system (characterized as it is by the presence of HFTs, systematic strats, programmatic trading and the proliferation of passive investing) has never been truly stress tested. The events that transpired on the afternoon of i) Monday, February 5, ii) on Wednesday, October 10 and iii) the flash-crashing madness that unfolded on August 24, 2015, certainly seem to suggest that when it is, it will fail (or at the very least not pass with flying colors).
Importantly, the dates mentioned above are but three examples of something that happens on a smaller scale all the time. There have been probably a dozen other acute episodes since 2008 and God only knows how many fleeting instances of “anomalous” price action. All of those events lend credence to the notion that something isn’t quite right, and that the proximate cause of these anomalies is likely to be the presence of machines.
When it comes to passive investing, I’ll just quote myself from a piece published here back in June:
Passive investing presents its own set of risks which aren’t well understood and making matters worse, even suggesting that the epochal active-to-passive shift has the potential to cause problems is taboo in polite company. After all, passive investing is what saves retail investors from themselves by discouraging day trading and the fact that passive vehicles come with rock-bottom fees has ostensibly freed Joe E*Trader from the tyranny of high cost active management.
The problem, however, is that these passive flows combined with what Howard Marks has described as a “perpetual motion machine” dynamic, have created a self-feeding loop, encouraged by the post-crisis monetary policy regime which kept volatility anchored and transformed “BTFD” from a derisive meme about retail investors into a viable (indeed, an almost infallible) trading “strategy”.
If that self-feeding dynamic ever slams into reverse, there are questions as to the durability of the mechanisms that underpin it (e.g., Will the ETF model actually crack, as it did on August 24, 2015? And what about credit ETFs? What happens to HY and EM bond funds when the underlying liquidity mismatch is exposed?)
And then there’s “smart beta”. Factor-based strategies almost certainly played a role in exacerbating the wild swings from Growth to Value and back again in October and the size of those swings likely contributed to the forced deleveraging by hedge funds, whose positions in Tech and Growth were bludgeoned.
Again, modern market structure makes things more stable on the surface (a veneer of stability, if you will), but beneath the surface, it’s an entirely different story. Fragility is the defining characteristic of modern markets and that was exposed both in February and last month.
In a brief post-mortem of the October mayhem, JPMorgan’s Marko Kolanovic blames a miscommunication between the Fed and the administration for the selloff, but notes that things were aggravated by the dynamics described above.
“In 2015, we were saying that systematic investing and electronic liquidity provision can yield any price outcome regardless of fundamentals”, Kolanovic wrote on Wednesday, before characterizing systematic flows, low liquidity and HF deleveraging as “the fuel” for a selloff that was catalyzed by politics.
In their piece, Goldman reminds you that changes “in the type of investing, with a large amount of investment in either passive or quant strategies can exacerbate market moves.” Hopefully, you didn’t need that reminder, but there it is anyway.
“While volatility has been relatively low in recent years, vol of vol has picked up since the 1990s”, the bank continues, before observing that “S&P vol spikes have in recent years become both larger and faster [with] the 10-year average volatility of S&P 500 1-month volatility increasing since the 2000s [and] the 5-year vol of vol increasing even more recently, indicating that this is not skewed by the global financial crisis.”
What accounts for the increase in vol of vol? It’s simple, Goldman says. It’s down to “changes in the market microstructure.” You should be able to make this list on your own, but just in case, here are the culprits:
- Changes in bank regulation have reduced liquidity across assets.
- The rise of systematic investing, e.g., passive/smart beta strategies that reduce liquidity, can drive crowding.
- CTAs, risk parity and volatility target funds, which often invest very procyclically.
- Levered or liquidity-constrained exchange-traded products, e.g, on high yield credit or commodities.
- Short vol carry strategies, e.g., short VIX ETPs.
Needless to say, each of of those bullet points would be disputed by, in order, proponents of the post-crisis regulatory regime, ETF providers, buyside quants, ETF providers again and Seth Golden, who can be reached by calling the customer service desk at the local Target super center (I’m just kidding, Seth – I’m sure you’re doing fine).
But whenever you hear objections from any of those folks, just remember that every time one of these acute fragility events (e.g., October 10, February 5) comes calling, their objections become less and less credible.