Opus 5: Will The Future Be More or Less Volatile?
Along with Soundscapes, Geopolitics, The Amish, and Nico Cartosio
"Never think that lack of variability is stability. Don't confuse lack of volatility with stability, ever." - Nassim Taleb
It is hard to argue there has been a better thinker and writer in modern times than Nassim Taleb when it comes to risk. His Incerto book series is more important than any financial textbook I have ever read. This post is not a regurgitation of Taleb’s thoughts on risk shows itself in markets; there are many of those out there already. Instead, this is a look at the following questions:
Will humans get better at understanding risk, and therefore, volatility? Will the future be more or less volatile?
Throughout 2019, I dove headfirst into the asset class of volatility. Chris Cole and the world-class Artemis team, Taylor Pearson and his Mutiny Fund, Sha Capital, 13D Research, and many others have led the way on understanding, quantifying, and leveraging volatility post-financial crisis. In my financial education, the existence of volatility and unknown risk was mostly brushed away as just something that happens. They were wrapped up in the idea of “Beta” and had to be accounted for in the asset pricing models (CAPM).
But, in the words of Chris Cole, volatility is the only asset class:
People say, “Is volatility and asset class?” I say it’s the only asset class. Because if you decompose the returns of all these different strategies into what they really are, they tend to either look like short vol or long vol. In that sense, you can simplify the institutional portfolio into those broad buckets. […] And the average institutional portfolio is just a 98% short volatility portfolio.
There are three incredible reads I recommend absorbing in parallel with the below:
Also before starting, it is helpful to provide mutually-agreed-upon definitions.
Volatility
First and foremost, what is volatility? Artemis sums it up better than anyone else I have come across:
"Volatility as a concept is widely misunderstood. Volatility is not fear. Volatility is not the VIX index. Volatility is not a statistic or a standard deviation, or any other number derived by abstract formula. Volatility is no different in markets than it is to life. Regardless of how it is measured, volatility reflects the difference between the world as we imagine it to be and the world that actually exists"
The investment community often conflates risk with volatility. In security analysis 101, Beta (β) is the "measure of the volatility, or systematic risk, of an individual stock in comparison to the unsystematic risk of the entire market", but risk and volatility are different things, as Artemis points out. Risk is the known and unknown things that can happen, which will create a different future than we expect. Volatility is the quantification of how big of a delta there is in that difference. The higher the delta between our perception of reality and the truth, the more significant the volatility.
As Artemis points out in their mission statement, "Volatility is not fear. Volatility is not the VIX index." The Vix peaked on 10/18/2008, this was after the S&P 500 gave up 79% of it's total $87.41 decline from $156 to $68.92. In other words, a vast majority of the overall market risk (if we stick with the definition above) was gone already, but the Vix said otherwise.
And that brings us to the next definition...
The Future
Next, we have to define "the future" and along what timeline does one answer the question posed in the title. I think it is best to define the future as a continuum rather than a point in time and while I understand that is a mystic dimension to think upon, volatility happens across time.
For the sake of this discussion, the future is defined as the next handful of macroeconomic cycles which have been 10-12 years from start to finish.
Quantifying Volatility
The comparison of “more or less” is another difficult measure to wrap one’s arms around. We already know the VIX isn’t the true volatility benchmark, but what is?
In markets, volatility manifests itself through velocity, or slope, of change. These rapid changes can happen in either direction, but, markets normally take the stairs on the way up and ride the elevator (or cliff jump) on the way down. With that in mind, the quantification of “more or less” will be the marrying of both the amplitude of change within financial market prices but, more importantly, the velocity and slope at which that change occurs. It is impossible to argue that the last two months have been the most volatile time in the history of modern financial markets, but where do we go from here?
The Future and Psychology of Volatility
People often point to the human psyche as the reason there will forever be unforeseen risk, and therefore volatility. I can’t completely accept this answer because human psychology changes over time. Looking at human greed, most cultures have moved from feudal systems to free-form capitalist states to regulated capitalist states and, finally, to socialist economies (this is an entirely different post, but I believe all cultures end up as democratic socialist states).
As more and more basic needs are solved, human greed diminishes and selflessness propagates. This taming of the human psyche lessens the overall amplitude of the greed and fear sine curve business cycles follow. There were never philanthropic foundations run by the top billionaires of society a thousand years ago. The expected return on the Bill and Melinda Gates Foundation's grants and donations is zero percent. Philanthropy is just as big of a status signal as big houses and irresponsible spending.
Zooming out, as seen below, rates (otherwise known as expected risk —> risk = reward) have been marching their way to the lower bound for the last 700 years.
Another interpretation of the above is that growth has declined since the cost of money follows growth and inflation. But, the chart should have reversed in both the late 1700s as the industrial revolution took off and in the Post Wars era as global growth exploded.
Alex Danco takes an interesting stance on this trend and risk in his interview with Jonathan Hsu,
“Well, of course it makes sense for interest rates to fall across generations; in the long run, we get better at taking risks.”
In addition to building things, bubbles also unearth previously unknown risk that can then be dealt with either through transparency, regulation, or basic hedging. The early financial bubbles - East India Trading, British Railway, etc. - suffered from a lack of informational transparency within company performance, market dynamics, and, as a byproduct, appropriate pricing. As a result of the Railways Manias, the first stock ticker was invented to provide capital managers with honest, efficient pricing. Accounting regulations like Sorbanes-Oxley and others made sure we wouldn't see conglomerate bubbles ever again as a result of their convoluted accounting practices. Further, It is unlikely we will ever see another crisis involving off-balance sheet risk hurting banks because of the 2008 crisis and subsequent capitalization ratio regulation the banks had placed upon them. And because of increased transparency, we can more accurately measure and model risk resulting in more accurate hedging structures.
It is clear we are continuing to play Whack-A-Mole when it comes to systemic risk but will the risks every stop popping up to our surprise?
Hedging one’s bets via derivatives has helped with this decline in known risk. But, the proliferation in derivatives can backfire and create an impossible unwinding in those trades.
Nathan Black of Sha Capital provides an interesting counter-argument to Danco’s thought,
"The future will be volatile. More global interconnection → more non-linear relationships → more systemic risk and uncertainty → more volatility."
The butterfly / chaos theory grows over time as both systems and cultures continue to intertwine. In 2008/09, subprime mortgage failures spread throughout the global banking sector as the same assets were securitized an infinite number of times and the first few mortgage defaults were innocently ignored. A tiny, exotic food market in China with less than stellar cleaning standards created the sharpest decline in asset values ever because our world is increasingly flat.
Market sensitivity is also continuing to worsen as this interconnection shows market participants how lethal it can be. Artemis provides insightful data here:
The above shows the most recent market regime (2017 - 2019) as being the most sensitive to basis moves in the market. In the past, the underlying market would need to crater -10% in order to have the VIX jump 20+%. Today, only a drop of 1-2% is causing the same expected volatility. The last handful of years gained notoriety for the lack of perceived, tangible volatility in the day to day markets. But, when markets did inevitably move, capital allocators did not take it lightly because it was a foreign feeling. But why was it?
The Third Body
One of the most influential pieces on my investment thinking over the last few years has been Ben Hunt’s Three-Body Problem. Paralleling the physics three-body problem, Ben outlines the fact that the two original market participants (buyers and sellers) can no longer rationally react to one another and find equilibrium due to the entrant of the third body: central banks.
Ben’s allegory provides a helpful visualization around market forces in saying that market participants interact with one another through some sort of abstract gravity. The larger the buying object is, the larger its gravity. But the third object trumps this effect,
What we have to accept is that there is an Object 3 that has moved into a position such that its gravity absolutely swamps the impact of Objects 1 and 2. This Object 3, of course, is an extraordinary monetary policy, specifically the purchase of $20 trillionworth of financial assets by the Big 4 central banks — the Fed, the ECB, the BOJ, and the PBOC.
$20 trillion is a lot of mass. $20 trillion is a lot of gravity.
But what does this mean for volatility?
The answer depends on one’s belief of if the monetary bodies can effectively tamp down the effect of the difference between our perception of the current world and the actual reality of it. The worldwide response to the virus has been nothing short of epic and its quantified scale dwarfs the governments’ responses during the World Wars. As of this morning (4/29/20), the market is only 1.7% away from being break even on a 52-week basis and it is has made back more than half of its losses since the pre-virus euphoric high. It is a tough time for fundamentally driven short-sellers. But, it is impossible to fight the Fed.
My answer to the question is a general leaning towards the “less” side of the spectrum. The basic ideas of money and markets have been changed as a result of the 2009 crisis and more so by the current crisis we are living through. The monetary policy groups have the biggest hammers (rates and money supply) of them all when it comes to combatting the seemingly never-ending moles that keep popping up.
With that said, it is a fun (yes, I know I need more hobbies if I am describing the below as fun) exercise to list out the known unknowns on the horizon that could cause headaches:
Another zoonotic health pandemic — see Dennis Carroll’s thoughts here.
China’s anger as a result of being the scapegoat for the virus and its return to old practices around trade and competition.
Iran - remember just a few months ago when we bet that was going to cause WW3?
Asian structured products further unwinding
State bankruptcies and public pensions failing
The far more dangerous ones are the unknown unknowns that we don’t even know exist yet. Inherently, there isn’t much to write about here…
With the above fear-mongering in mind, it is important to equally weight the other side of the trade. Over the last millennia, betting against human ingenuity has proven to be a bad trade. And I don’t plan on holding that trade anytime soon.
Homework Reading
Soundscapes of Cities During Covid-19
Atlas Obscura has an excellent article this week on the changing sound profiles of cities during the global lockdown. I currently live in New York City but I am an avid backcountry hiker — the two extreme bookends when it comes to sound. The author also started the One Square Inch of Silence project where he found one of the quietest places in North America. The marker is 12 miles from the closest registered road.
The Geopolitics of the United States, Part 1: The Inevitable Empire
I finally got around to finishing this read. It is an extensive run-through of America’s relative geographical advantages, one of the reasons the country has had the success it has. It is a fascinating read - especially if you were a Risk and Civilization player growing up:
The American geography is an impressive one. The Greater Mississippi Basin together with the Intracoastal Waterway has more kilometers of navigable internal waterways than the rest of the world combined. The American Midwest is both overlaid by this waterway and is the world's largest contiguous piece of farmland. The U.S. Atlantic Coast possesses more major ports than the rest of the Western Hemisphere combined. Two vast oceans insulated the United States from Asian and European powers, deserts separate the United States from Mexico to the south, while lakes and forests separate the population centers in Canada from those in the United States. The United States has capital, food surpluses and physical insulation in excess of every other country in the world by an exceedingly large margin. So like the Turks, the Americans are not important because of who they are, but because of where they live.
I wrote previously on why our healthcare system is so broken in comparison to others. The main factor was that our admin layer is bloated due to the complexity of our two payer system. Maybe, the solution is to just be more like the Amish:
Second, the Amish are honorable customers. This separates them from insurance companies, who are constantly trying to scam providers however they can. Much of the increase in health care costs is “administrative expenses”, and much of these administrative expenses is hiring an army of lawyers, clerks, and billing professionals to thwart insurance companies’ attempts to cheat their way out of paying. If you are an honorable Amish person and the hospital knows you will pay your bill on time with zero fuss, they can waive all this.
Today’s Music
Nico Cartosio has emerged as one of the best modern contemporary composers. His piece, Snow Above The Earth, has been a long-time resident of my “practice” binder on my piano. For lack of a better word, the piece is an absolute roller coaster and no one shows that more accurately than Nikolai Kuznetsov:
I think the range of emotion within the piece is an appropriate allegory of the world today and everything going on. I recommend watching the piece as well to appreciate Nikolai’s pure skill.
The Encore:
Sonata in A Minor K.109: Adagio — Domenico Scarlatti
Sonata in A Minor K.59 - Domenico Scarlatti (yes, I listened to a lot of Scarlatti this week)