Look, It’s The Market Fragility Discussion Again

It’s the same story over and over again. Stability breeds instability and modern market structure facilitates and amplifies the dynamic.

The short version is just that volatility determines exposure, so in calm markets, exposure and leverage rises. Time and again we’ve seen this conjuncture coincide with an “insulating” effect from dealer hedging flows, which act as synthetic “plunge protection,” in turn keeping markets rangebound, driving realized vol lower still, dictating more mechanical exposure adds, and so on.

That creates the conditions for an “avalanche” in the event some exogenous shock comes calling. Trend followers pare exposure as spot careens through triggers, market depth (liquidity) deteriorates as volatility rises, price swings become even more exaggerated, hedging flows turn pernicious (instead of “buying the dip,” selling begets more selling) and, finally, the vol control universe de-leverages on a delay as realized vol is pulled higher.

This isn’t inevitable. Not every precariously heavy snow cover results in an avalanche. But the dynamics outlined above have played a role in some of the most infamous drawdowns witnessed over the past several years. The conditions for such a domino effect are (in part anyway) in place currently, something discussed here at length on numerous occasions last month.

“The combination of the new low vol regime and strong equity returns has resulted in one of the best risk-adjusted performances for equities since WW2 in the past six months,” Goldman’s Christian Mueller-Glissmann said, in a new note, adding that “this has likely attracted increased positioning from systematic investors such as risk parity and vol target strategies and also CTAs, which have had relatively low equity allocations since the recovery from the COVID-19 bear market.”

Arguably, modern market structure has increased the risk of VaR shocks and generally made markets more fragile. There are plenty of people (many of whom are ostensibly “smarter” than me, although I’ve been forced to reevaluate my definition of “smart” over the past five or so years) who will tell you that’s nonsense. They might even suggest I’m parroting a less abrasive version of a narrative long pushed by some of the very same commentators I habitually deride.

But this is a “Me or your lyin’ eyes” scenario. Modern market structure increases fragility. It just does. This is a (very) unscientific assessment, but when you see a drawdown and it “feels” like it’s accelerating faster or is just generally “messier” than it “should” be, that’s not just your imagination — it’s modern market structure working its “magic.”

The Goldman note cited above was innocuous, by the way. So, I’m not trying to ascribe any opinion to the bank. They’ve said plenty over the years about these dynamics in explicit terms. In this instance, Mueller-Glissmann simply reiterated that “volatility episodes… have become shorter over the past twenty years [and] vol of vol has been on an upward trend since the GFC.” The visuals (below, from Goldman) illustrate the point(s).

The bank elaborated. “Volatility tends to linger over time [but] the correlation between the previous and the following six-month volatility has not been stable and has declined towards zero over the past decade,” Mueller-Glissmann went on to say, before sounding a politely cautious tone. “Because the link between past and future volatility has weakened, investors should be cautious in extrapolating the current low volatility regime too far in the future.”

As you can imagine, the odds of volatility rising are seen as higher if the “triple peaks” thesis is even a semblance of accurate. If growth, profits and stimulus all wane together, the read-through for markets isn’t great. Mueller-Glissmann also called nosebleed multiples a “speed limit” for returns and noted that US tax reform remains “a key downside risk to S&P 500 earnings estimates.”

The most important takeaway, though, is captured in this simple observation from Goldman: “There is always a risk that markets get snapped out of the new low vol regime in the event of a continued deterioration of the macro backdrop near term, either due to a large growth or rate shock.”

While Mueller-Glissmann was quick to note that doesn’t have to presage a “high vol regime,” I’d gently suggest that the concept of “regimes” might be losing some of its utility in a market where “shocks” can trigger cascades and otherwise amplify drawdowns.

It’s certainly true that the (perceived) increase in the occurrence of so-called “fragility events” hasn’t prevented long-term investors from enjoying triple-digit gains over the past dozen years. Ironically, that’s in part because some of the same dynamics also work in the opposite direction, when low volatility dictates increased positioning and encourages vol selling for yield enhancement.

As Mueller-Glissmann put it, “being under-invested during low vol regimes can be costly.”