‘Sure,’ The World’s On Fire. But Strats Controlling $1 Trillion Will Still Buy Stocks

I love reading copy sometimes.

Whenever the world is going to hell in a handbasket, journalists don’t usually have as much leeway as they might need to convey the severity of the situation, so they’re left to simply document facts.

Of course, when things are acute, simply listing facts comes across as an attempt at dry humor, even when it’s not. Consider the following bit from Bloomberg’s Yakob Peterseil, for example:

Sure, this is still 2020: President Donald Trump has yet to concede the election to Joe Biden. COVID hospitalizations are hitting fresh records. [And] markets are awaiting a stimulus plan from a bickering US Congress.

Yeah, “sure,” the President of the United States is refusing to hand over the keys to the Oval Office after losing an election in unequivocal fashion.

And “sure,” hospitalizations tied to a deadly pandemic that’s killed five times more Americans than Vietnam (going by battle deaths, as tallied by the Department of Veterans Affairs) are now at a record.

And “sure” Congress clearly cares more about defending artificial lines in the sand than they do about saving tens of thousands of lives and businesses, even when, if we’re all being honest, there is no such thing as a “budget constraint” for the issuer of the world’s reserve currency.

But hey, other than that, volatility is set to subside, and that will likely catalyze mechanical re-leveraging from a systematic investor universe that, in total, controls more than $1 trillion.

That might seem like a non sequitur, but the gist of the Bloomberg piece mentioned above is that the vol-control crowd is poised to provide a latent, mechanical bid for stocks assuming realized volatility grinds lower post-election. That assumption is juxtaposed with the turmoil in D.C. and the rather acute public health crisis which is worsening quite literally by the day.

Regular readers are well apprised of the dynamics here. As realized vol moves lower, the exposure toggle for vol-sensitive investors is mechanically reset higher, dictating a bid for equities.

The Bloomberg piece cites a BNP strategist in projecting that one-month realized will get back “into the low-teens” by Q1 of next year.

On Friday, JPMorgan’s Marko Kolanovic flagged the potential for volatility to subside, especially if policy becomes more predictable going forward.

“There is the potential for less market volatility (e.g. no more market disrupting tweets),” he wrote. “Lower volatility could result in inflows in vol-sensitive strategies,” Kolanovic added, noting that “current positioning is moderate” with volatility targeting in just the ~10th percentile, hedge fund equity beta in the ~20th, and CTAs in the ~40th.

Similarly, Deutsche Bank’s vol control model pegs exposure in just the ~9th percentile.

The idea, generally speaking, is that the virtuous self-fulfilling prophecy will unfold, as declining volatility will lead to re-leveraging and thereby even lower volatility, pulling in CTAs and risk parity. (The gang’s all here!)

On Friday, Deutsche’s Parag Thatte, Srineel Jalagani, and Binky Chadha noted that the post- election drop in implied vol was “entirely driven by a fall in risk premiums, with realized vol in fact rising.”

Late last week, Nomura’s Charlie McElligott reiterated the scope for the vol complex to help feed a year-end melt-up. He cited the potential for “second-order vol control, systematic re-leveraging” to kick in, as exposure gets dialed back up “on the implied vol —> realized vol compression ‘averaging-down’.”

On Nomura’s models, CTA equities exposure sat in just the 17th percentile since 2011, while vol control’s allocation was in just the 16th percentile having sold ~$27 billion over the two weeks headed into the election.

Nomura, QIS

The upshot to all of this is that, if you accept the BIS’s estimate of the total AUM for these systematic cohorts, strategies controlling more than $1 trillion in assets are underweight equities.

And they aren’t looking at valuations when it comes to dialing up their exposure. They’re looking at volatility.


 

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6 thoughts on “‘Sure,’ The World’s On Fire. But Strats Controlling $1 Trillion Will Still Buy Stocks

    1. The more I read H the more I realize that most of the market is really unknowable. Opinions may be formed but true knowledge of actual outcomes is just not there. As they say in Hollywood, “No one knows anything.”

  1. Great post as usual.

    Awesome. This will be a great play going into year end. Let the indicators mellow out from Monday’s whatever, chill for some number of trading sessions. Pet the neck of $VIX. Then unleash the animal spirits for the year-end melt up.

    Seems that any melt-up won’t really care about our government’s abject failure to help the nation in a time of mass grief and suffering, nor about anything 45, arguably the worst US president up to this point, could possibly do. Barring a breakout of a hot war or some other, well, let’s just hope nothing goes wrong, should be a solid trade.

  2. The models don’t care about Covid, politics etc. These “risk parity” models appear to be a derivative of simple trend-following models, don’t they? Derivative because they react to changes in volatility which are believed to be mainly directional = markets up/vol down.

    No different than options skew.

    As such, these kind of models are self-fulfilling as early buyers pull in others behind them.

    Pity the poor journalists who are asked to explain why “the market” is going up in the face of bad news. How many Americans will understand what volatility-driven “investing” is. Or how much it has come to dominate stock market direction.

  3. I don’t know… Moscow Mitch and Colonel Bonespur just don’t appear to be worried enough. There’s something afoot. I suspect that the electors that attend the Senatorial approval and pronouncement of the election results may not relay the true results from each state. Mitch would have no problem in passing along the altered results as genuine and proclaim DJT as re-elected.

  4. I see options on individual stocks trading below recent realized volatility. Is volatility over because the election is over? I’m a buyer of volatility, not a seller (both long and short).

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