On earth as in markets, humans have been trying to domesticate mother nature for their own benefit. But Nature always takes back its place.
- Since humans settled down, they have been trying to domesticate mother nature for their own benefit, for instance by managing watercourse to prevent floods. Citizens asked local-authorities to manage those risks
- The same is true for markets. Citizens- investors asked Central Banks and Governments to do everything they could to prevent market natural volatility
- But natural market volatility is good for markets in the long run. The more institutions will artificially compress volatility, the more markets will be exposed to markets shocks potentially turning into financial flood
Since humans settled down, they have been trying to domesticate mother nature for their own benefit. Over the past millenniums, watercourses of rivers have changed, flood after flood. As mankind became sedentary and settled down close to rivers for practical reasons (energy, drinking water, sewers, etc) they needed the watercourse to be stable. Citizens asked local-authorities to manage those risks, and local-authorities built embankments, dams upstream, and managed to reduce the number and frequency of floods. The downside of this approach is that people get used to this apparent calm and stability of things. They start building houses very close to the river, take the absence of floods for granted and if something goes wrong (embankment not high enough, dam failure, etc) the damages are dramatic, costing human lives and billions in insurance coverage.
The same is true for markets. In the analogy, citizens are investors and they asked Central Banks and Governments to do everything they could to prevent market natural volatility. Post 2008, Central Banks have gotten particularly involved in managing investor’s expectations, with forward guidance and preemptive actions, meaning that Central Banks were and still are acting before any risk materialize, trying to anticipate and avoid any slowdown. But natural market volatility is good for markets in the long run, the first and most important benefit being that volatility prevent from excess leverage and hidden convexity risks (Leveraged short Vix ETN, Autocalls, etc). The more institutions will artificially compress volatility, the more markets will be exposed to markets shocks potentially turning into financial flood.
We looked at the evolution of Equity markets with regards to movements. For each year since 1991, we counted the number of “large moves”, that we define as a daily move of the S&P500 above 3%, up or down, and “large shocks”, that we define as a daily move of the S&P500 above 4 standard deviation away from the average daily move of the index for the past year. “Large moves” then represent movements in absolute terms where “large shocks” represent movements in relative terms to the recent past. As we see in the below chart, in 2018 we have experienced 5 “large shocks”, 3 in early February, 1 in October and 1 in December. As a reminder, if Equity returns were normally distributed, the probability for a daily movement to be within the +/- 4 standard deviations is equal to 0.999936657516334, meaning that such a large shock should only happen approximately once every 43 years.
Of course, Equity returns are not normally distributed and we look at moves relative to a recent past, but still, the post 2008 era seems very prone to prolonged periods of exaggerated low volatility, followed by sudden spikes of volatility, which is eventually very disturbing for investors. So, with all due respect, here is our advice to Central Banks and Governments: “To Prevent Huge Markets Shocks, Let Them Move”.
At Seeyond, volatility is a core element of our investment processes. We build minimum volatility Equity portfolio by choosing stocks with low volatility and low correlation, we use markets volatility to fine-tune asset allocations in our Multi Asset portfolios, and we use derivatives to invest directly on market volatility in our Volatility and Overlay portfolios. Beyond standard measures of market volatility, we look deeply at the structure of markets to fully understand what drives market movements and what risks may be hiding below the surface.
Published in October 2019
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