Is Low Market Volatility a Troubling Sign for Your Portfolio?
It was said that right before the Titanic made its final fatal descent into the icy waters of the Atlantic, it was still and quiet for several moments, eerily hanging perpendicular in the water before making its long plunge to the bottom.
Is that where the markets are right now? Is this the calm before the storm?
We are experiencing a period of low volatility in the stock markets that may look like stability to the average retail investor. In fact, this is the lowest level of volatility in the history of the stock market. Institutional investors with the big banks however, see this period of low volatility as a sign to diversify.
This article in ZeroHedge makes the case that big banks are shoring up cash positions like crazy:
A few weeks later, JPM' Marko Kolanovic warned that complacency will end in "catastrophic losses" for short vol strategies followed promptly by Deutsche Bank's Aleksandar Kocic who demonstrated that there is no scarcity of scary adjectives when he likewise warned that the current period of market "metastability" will lead to "cataclysmic events."
It is clear from the below analysis that major institutional investors with the biggest banks in the world are getting quite nervous about the signs they see in the markets right now. Price-to-earnings ratios are dangerously high. Stocks are very expensive and low volatility means that markets are showing signs of complacency. The most vulnerable position you could be in right now is having an overdependence on the continuation of these high valuations and a portfolio that is not properly balanced and diversified.
In a note by Goldman's Christian Glissman seeking to explain "The upside of boring - risks and asset allocation in low volatility regimes", the vol strategist joins the bandwagon and writes that while "low volatility periods do not have to end in tears, they often do." His explanation:
Volatility tends to cluster and is often low for a good reason – this indicates investors should add risk during those periods. However, a prolonged low vol period can also eventually result in excessive risk-taking and latent risks from elevated valuations. But moving out of a low vol period does not have to come with a material ‘risk off’, at least initially. Usually volatility tends to spike and equities settle into a higher volatility regime and the average drawdown is less than 5%.
Markets often enter a higher vol regime before there are larger equity corrections, usually 6-24 months later. This suggests a more gradual risk reduction as markets shift into a more persistent higher volatility regime as the macro backdrop worsens. Currently, we see little recession risk in the next 12 months although growth momentum may have peaked and the US economy is moving more late cycle.
So if not a recession, what could unleash more images of traders with hands on their faces? Here Goldman channels the latest note by Matt King, and says that the "bigger risk could prove to be central bank tightening, which could drive more volatility in the near term, especially owing to the elevated uncertainty around the balance sheet runoff by the Fed and ECB."
Further, volatility can spike due to unexpected shocks and tail events – with higher vol of vol risk, running increased cash allocations and some tail risk protection appears sensible. This is particularly true as valuations across risky assets remain high, resulting in poor asymmetry for LT returns.
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