“All we have left to show for our three year liquidity orgy is the most correlated period in modern finance.”
That’s the succinct and telling view of volatility guru Christopher Cole at Artemis Capital Management.
He’s out with a new report on Friday, which takes a refreshing look on matters volatility, correlation and liquidity.
Above all, he says, we’re now at a uniquely challenging juncture when it comes to the volatility landscape. In that context, the rise in volatility in August 2011 was remarkably easy to identify (especially with hindsight).
But that sort of low-hanging volatility fruit is now well gone.
As Cole now notes:
Earlier this year it was clear the volatility markets were bracing for a correction following the end of QE2. With this thesis in mind Artemis recommended shorting the long-end of the VIX futures curve where volatility of volatility (“VOV”) was expensive and replacing that exposure with more sensitive volatility positions on the front of the curve where VOV was cheap.
The strategy was extremely effective when equity markets collapsed and the VIX futures curve inverted while options skew flattened. What happens from here is much more difficult to understand.
The problem, he says, is the market’s general lack of imagination when it comes to the potential for greater realised volatility. To put things in perspective, Cole suggests that had there been a VIX index in the 1930s, it would have recorded levels of as high as 100, blowing the intra-day high of 89.53 reached on October 24, 2008 out the window.
While still improbable, Cole believes an uncontrolled Greek default could put those levels within the realm of possibility.
What to do in terms of volatility hedging in that environment? Cole suggests playing both tails of the probabiltiy distribution.
But before doing so, it’s really essential to understand the relationship between volatility and money supply itself. To wit, a series of extremely compelling charts plotting the historic relationship beteween money and volatility:
As Cole notes:
Extremes in the volatility of the money supply, defined here as annualized monthly changes in M1 through M3, reflect important turning points in the US economy. To this effect we have never experienced a spike in M1 volatility as large as what was recorded in August 2011 without an ensuing recession. When the money supply is volatile the risk of a recession grows incrementally higher. The volatility of M1, defined as physical currency in circulation and checking deposits, typically spikes before the onset of a recession because market participants transfer risk assets back into physical cash (see graphic). In this sense, money is one of the only assets whereby volatility spikes occur in conjunction with high demand (US Treasury securities also come to mind).
The evolution of cash volatility provides clues to the mystery of elevated global correlations. The volatility of the money supply has been climbing higher since the 1970s and the relationship between the volatility of M3 and M1 resembles an expanding sine wave or feedback loop (see chart). This is indicative of the fact increasingly violent shifts in the M1 physical cash supply are not matched by higher volatility in the broader M3 measurement that estimates credit creation and animal spirits(2). Therefore it takes vastly more liquidity today to rouse the shadow banking system but at the cost of higher potential for market dislocation.
In Cole’s opinion, if volatility can be considered the heat of the current fire, correlations are the winds stirring the flames. After all, the implied volatility of an index is much more sensitive when the average correlations between the components of the index are greater. So, as correlations rise, so does the volatility of volatility — observable in the recent highs struck by the volatlity of the VIX:
This means it’s becoming increasingly hard to make money from money. As Cole states:
The alpha derived from active management can be decomposed into two components 1) asset selection and; 2) volatility bias. In highly correlated markets the asset selection component is negated and alpha becomes increasingly driven by rising and falling vol. When this happens many classic hedge fund strategies converge to simple synthetic volatility trades. This could be one reason why many high profile managers including Druckenmiller and Soros are quitting the business while they are still ahead of the curve.
Cole says a phenomenon known as “serial correlation” could be to blame. It’s the counter-theory of modern derivative pricing theory, which suggests that knowledge of past prices has no bearing on future returns. Here, quite the opposite, past returns become increasingly correlated with future results. Though, there are actually two types of serial correlation, positive and negative. The negative type measures the propensity for today’s return to be the opposite of yesterday’s and rewards reversion to the mean strategies. Positive correlation, meanwhile, is associated with consecutive moves in the same direction, rewarding trend-following strategies.
Looking to history, an interesting point emerges. The last time the rolling one-year serial correlation of daily lagged logarithmic returns in the DJIA reached a generational peak was on May 25th 1971. That was less than three months before Nixon surprised the international monetary system on August 15, by cancelling the direct convertibility of the United States dollar to gold.
The move is significant because:
After the “Nixon Shock” positive serial correlation in DJIA daily returns began a four decade decline. On August 11th, 2011 we reached the lowest levels of serial correlation in the 82 year history of the DJIA almost exactly 40 years to the day that Nixon abandoned the gold standard.
For those who believe the above to be a statistical coincidence, Cole says a random coin flip test fails to show anywhere near the serial correlation drift seen in the DJIA results.
Thus, it’s very possible that the DJIA negative serial correlation drift we’ve seen in the last 40 years — one which rewards mean reversion strategies — has been the result of monetary expansion. In which case, asks Cole, does today represent the beginning of the new era of trend following and volatility?
Either way, Cole suggests, it’s time to take a new look at what volatility really is:
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, Black-Scholes input, GARCH model, or any other number derived by abstract formula. Volatility is no different in markets than it is to life. Volatility is an instrument of truth. Regardless of how it is measured it reflects the difference between the world as we imagine it to be and the world that actually exists. It is the fire in Plato’s cave that illuminates the shadows of reality for those chained to the darkness. It is as global as a violent revolution resulting in social change; or as personal as an exhilarating relationship with a complex woman who is very there and then inexplicably gone. Volatility hurts but is necessary for growth. In nature volatility is so fundamental that the trees of the great sequoia forest will not release their seeds without first sensing heat from wildfires. It is from the flames of change that we derive the potential for healthy resurrection and birth. In markets and in life if we don’t recognize the truth in each moment, deny revolution, suppress volatility no matter how painful, we will not allow ourselves to prosper.
Volatility is change and the world is changing. The truth is that Greece will default. The truth is that if our leaders continue to deny our problems history tells us the US will eventually default. These shocking events will hurt many people, markets will collapse, life savings will be lost, there will be violence, upheaval, and massive political change but you know what? The world will not end. When it is all said and done people will work, they will spend time with their children, they will cry, laugh, and love… life will go on. We will find a way to prosper if we relentlessly search for nothing but the truth, otherwise the truth will find us through volatility. Vive la vérité Vive le volatilité
Like we said. Compelling stuff.
For more of the note check out the Long Room.