Upside Volatility Is Rising, along with Fixed-Income Leverage

While the chair of the Federal Reserve is publicly worried about potential volatility when interest rates begin their inevitable rise, I am worried by the volatility on the upside.

There is very little in the popular press about upside volatility. When stock prices go up, the pundits tend to claim that it is due to some economic statistic. They don’t attribute the gains to market structure imbalance. Because academics want their students to be aware that prices can go down as well as up, they label the gains as rewards and declines as risks, which is a fundamental misinterpretation of the nature of risk.

For those who have the responsibility of managing other people’s money, risk is the permanent loss of large enough amounts of capital to threaten long-term goals for the use of the money. The academics wanted (and many still do want) a mathematical formula for risks, and they adopted standard deviation of returns, which has led to far too many people counting risk as volatility of returns, not impacts on outcomes. To meet the need to be able to define the volatility of “the market,” our friends in Chicago created the Volatility Index (VIX), a tradeable index that tracks the volatility of the S&P 500 Index.

The VIX Can Miss

We have just finished a four-month period during which the VIX doubled off a historically low base and then returned to low levels. However, this move did not capture the true saw-toothed movement in the marketplace.

My firm has been charged with managing a series of portfolios largely invested in mutual funds for different needs on behalf of one client. In the previous four-month period, we tracked 51 separate funds and separately managed accounts for this client. Although most of these portfolios invest in stocks, a number invest in fixed income. The movement of the VIX did not really capture the price movements.

In July, 39 of the 51 declined, which was echoed in September, when 49 were flat or declined. Our client should have been pleased that, in October, 43 of the 51 rose. Perhaps much more significantly, over the four-month stretch, 32 rose. At no point was the ability of these accounts to meet future funding needs ever in question. Thus, there was no real risk to their goals despite market gyrations.

Good News, Bad News

In a recent investment committee meeting, there was a discussion of moderately changing asset allocation in favor of domestic equities. A belief that we are entering a period of increased upside volatility was expressed. This view makes sense to me in the short run.

In previous posts, I referred to the media’s use of “handles” to describe surpassing round number levels: the S&P 500 at 2,000, Berkshire Hathaway at $200,000, Apple at $100, and now Alibaba at $100. It will be interesting to see whether Moody’s can rise to $100. The stock appears to have stalled out at $99. Also, can Goldman Sachs go over $200?

If investors, both institutions and individuals, translate these handles as rungs in a ladder reaching materially higher levels, we could see a wall of money coming out of cash instruments and into the stock market. (One investment banking firm is predicting a 3,000 handle for the S&P 500.)

If this wall of money enters the global stock markets without discipline, stock prices could gyrate upward in a speculative frenzy. If that happens, it would be the main remaining element needed to identify a major top.

Fixed-Income Leverage Is Mounting

Most stock investors don’t realize that the fixed-income markets are much larger than stock markets. Historically, price movements in these markets are smaller than those in stocks. In addition, almost all fixed-income investments have a maturity date; thus, banks, brokerage firms, and governments have felt comfortable allowing borrowers to borrow up to 99% in the case of currencies and somewhat less for other types of issues.

In modern times, it is not unusual to borrow money in a low-interest currency and buy in a higher-interest (riskier) currency. Often, the supplier of the leverage is a bank or brokerage firm that will be the recipient of the trading flow of the borrower. That worked well in the past. Today, each bank or brokerage firm for regulatory purposes has had to reduce the amount of capital that can be used by its trading desk to provide liquidity to those fixed-income accounts that need liquidity quickly.

The fundamental fallacy of governments bailing out financial and industrial companies is actually boomeranging and could make future collapses worse. Collapses occur because a large number of people make quick, poor judgments. One cannot force sound decisions by law, and indeed, we probably would not have the political leaders we have today if we could mandate sound decision making.

Governments don’t want to capitalize bailouts, so through regulation and legislation they are attempting to reduce the size of their exposure by limiting the size of the participants.

The Fed has now decreed that no financial company can have capital in excess of 10% of the combined liabilities of all the other banking institutions. This means that the United States will have at least 10 large banks.

Other nations have a much more concentrated financial community. Because US institutions are limited in the global markets, their foreign competitors may increase their share of the loans. In time, they will have to deal with large global failures, which will affect US institutions and put US investors at substantial risk. One of the problems facing all governments is that they can influence the global financial community but they cannot rule it effectively. Attempts to do so are creating a false sense of security, which, when the balloon pops, could lead to massive movements in the marketplace.

I would like to learn how big the potential problem is. There is no global tally as to the amount of money that is being provided to fixed-income investors, and these include important currency players.

When there is a major dislocation in the bond market, the institutions involved — and those that fear they may get involved — will reduce their support for all markets as they husband their capital before an eventual redeployment. Thus, one of the major risks to the stock markets is a sudden significant contraction in the fixed-income markets. This situation is called “contagion,” and we saw it happen to the Latin American markets when Russia defaulted.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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