Headed into December, one key part of the year-end, melt-up thesis is that realized volatility will continue to grind lower, triggering mechanical re-leveraging from vol-sensitive investor cohorts.
“As our thesis for a post-election, post-vaccine implied vol compression continues unabated, the second-order impact on systematic ‘vol control’—type strategies will continue providing supportive ‘buy’ flows in [the] coming days and weeks in the absence of another ‘shock,'” Nomura’s Charlie McElligott wrote, earlier this week.
The “absence of another shock” part is key, and not just because of the almost tautological relationship between negative shocks, higher volatility, and lower stock prices. More crucial is the self-feeding loop between market depth and volatility, a constant theme in these pages.
Read more:
Gather ‘Round Children, It’s Time For A Liquidity Ghost Story
‘Sure,’ The World’s On Fire. But Strats Controlling $1 Trillion Will Still Buy Stocks
I won’t revisit the entire subject here, as the point isn’t to pen yet another tome on the infamous “doom loop.” Rather, I simply wanted to note that with global equities tracking for one of their best months on record, market depth is still impaired on some metrics, and that leaves stocks perpetually exposed in the sense that if something were to go seriously “wrong,” selling flows would be magnified.
That magnification is tantamount to, and synonymous with, higher volatility, which is inversely correlated to market depth. If that sounds self-referential, that’s because it is. That’s the whole point. That’s the loop.
Underscoring this in a brief note dated earlier this week are SocGen’s Sandrine Ungari and Olivier Daviaud. After noting the rather dramatic run-up in global shares in November, they illustrate the market depth-volatility point with a visual depicting liquidity supply versus the inverse of realized vol.
As ever, the most glaring aspect of the visual is the extent to which conditions never fully recovered from the VIX ETP implosion that unfolded during the week of February 5, 2018 (affectionately known to market participants as “Volpocalypse”). After that event, new lows were hit during the selloff in Q4 2018 and then, of course, during March of this year.
“Liquidity supply in the market remains frail: at the bottom of the range since the start of our dataset in 2014 and in line with the levels of realized volatility,” Ungari and Daviaud wrote.
“At current levels, markets are well inflated, while economies will need a few more months to absorb the second lockdown consequences,” they added, before noting that if, as expected, “the path to normality is… a long one, with bumps along the way, liquidity is most likely to become a topic of concern” again at some point.
Meanwhile, SocGen’s sentiment indicator is hovering near “extreme” risk-on territory.
I should note (and I always try to include this pseudo-caveat in this discussion) that this isn’t meant necessarily as a “warning,” and especially not for “regular” investors.
The point, rather, is simply that modern market structure has a tendency to create “tinderbox” setups, and the liquidity-vol-flows feedback loop is part and parcel of that. It may not matter all that much if your investment horizon is decades, but for shorter-term traders and certainly for those of a “tactical” persuasion, this is a deadly serious issue.
New academic work further underscores the point as it relates to the potential for dealer hedging to exacerbate price swings in negative gamma regimes. “In the absence of any risk management, a dealer profit profile is potentially very volatile and non-linear,” the authors, Andrea Barbon and Andrea Buraschi, wrote, in a paper called, appropriately, “Gamma Fragility.”
“To limit their market exposure, most dealers delta-hedge by selling shares of the underlying asset [but] the optimal amount of shares to short changes depending on the intraday fluctuations of the underlying price,” they went on to say. “When the aggregate market gamma imbalance of dealers is large, the overall intraday activity of financial intermediaries may be substantial.”
Yes, it “may be,” and the conclusion from Barbon and Buraschi is hardly “news” to anyone who’s been paying any semblance of attention for the past decade.
“We document a link between large aggregate dealers’ gamma imbalances in illiquid markets and intraday momentum/reversal and market fragility,” they wrote, on the way to documenting all manner of “supporting evidence that intra-day momentum (reversal) is explained by the interaction of negative (positive) aggregate ex-ante gamma imbalance and market illiquidity.”
Again, there isn’t anything in the paper that’s going to surprise anyone who understands how modern markets work, let alone anyone who actually participates in them. But for everyone else, I’ve embedded the paper below, as it could be a “fun” weekend read.
Gamma Fragility
60 Pages Posted: 16 Nov 2020 Last revised: 19 Nov 2020
Andrea Barbon
University of St. Gallen
Andrea Buraschi
Imperial College Business School; Centre for Economic Policy Research (CEPR)
Date Written: November 5, 2020
GammaPaper
Since the largest Wall Street dealers became banks at the onset of the global financial crisis the market structure has changed. Capital levels and cost of this capital is now partially dictated by bank regulatory requirements. As a bank now, the investment banks used allocating less capital to markets as a way of getting regulatory required capital higher. That caused the unintended consequence of this type of market structure with a lean amount of capital supporting markets. In essence risk has been shifted away from the banks and towards investors and other market players. And at the same time the size of the financial markets has grown significantly, which makes the problem bigger. Unless regulations change, we will have to live with this market structure.
This market is very scary for me, historically, a fundamentals based investor. I liked to find stocks that were beaten down, where I thought the future looked bright. Against the back drop of a stock market that functioned in a manner that was considered “normal”.
I learned a huge lesson earlier this year- I might have miraculously figured out when to get out-but did not know when to get back in.
As of now, with a much better understanding of the currency printing impact on the stock market, I am “almost all in”, but super paranoid. I am worrying the most about the effect of the January 5 run off election on the stock market.