Understanding Volatility: back with a vengeance
Economic and liquidity indicators do a fantastic job of leading volatility.
The below is an excerpt from our 2016 Understanding Volatility report.
Central bank suppression of volatility is like trying to prevent forest fires by indiscriminately putting out all fires no matter how small. Although in the short-run there are no big fires, this often leads to denser trees and debris in many forests, which enables unusually large wildfires to burn.
It is extremely important to point out that low volatility in and of itself is not a problem. Volatility is serially correlated, and periods of low volatility follow periods of low volatility. Likewise periods of high volatility follow periods of high volatility. This is very much like one of the most basic methods of weather prediction. The rule that tomorrow’s weather will be like today’s is generally right. It is only wrong when the weather changes.
Professor Didier Sornette has cited comparisons of wildfires in Southern California and Baja California to show the counter-intuitive effects of aggressive suppression of small wild fires. Southern California has had aggressive fire suppression policies since 1900, whereas Baja California (north of Mexico) has essentially a “let-burn strategy” with no active management. As a result, Baja California tends to experience numerous small fires, which helps to avoid too dense a build-up of forest, which actually prevents very large wildfires. Conversely, in Southern California, aggressive micro-management of small fires actually resulted in growth of dense underbrush that results in occasional very large fires.
We believe forest fires are an apt analogy to volatility.
There are two key fundamental inputs that drive changes in volatility:
Rising leverage/falling leverage. This is the credit cycle.
Economic contraction/economic expansion. This is the economic cycle. Market volatility is highly correlated with economic volatility. Recessions are always associated with high equity volatility.
Sometimes these two cycles overlap, and sometimes they don’t. For example, there was growth with rising corporate leverage and volatility from 1996-2000. From 2003-06 there was growth with falling corporate leverage and volatility. Within these regimes, there are distinct episodes of volatility spikes and falls.
The legacy of this cycle will be central-bank intervention and balance-sheet expansion. By reducing the availability of “risk-free” assets, central banks force investors further along the risk and duration curves, lowering the risk premiums embedded in asset prices.
Get the full picture at variantperception.com