As a Goldman Sachs quant researcher, Emanuel Derman published a seminal research paper back in 1999 in which he said that there were volatility regimes. Sometimes volatility was low, sometimes it was high and one would transition from one regime to the next. Financial markets experienced such a regime shift the last couple of months, and not just in volatility but everything. That means what worked yesterday will not work today.
But the problem is that it often takes far too long for investors to smarten up and figure that out. They’ll cling to their short volatility, trend following, buy-the-dip strategies long after it has become apparent that those trades are no longer profitable. What investors need to realize is that they are facing a number of open-ended risks, with trade tensions between the U.S. and China at the top of the list.
Pundits say markets hate “uncertainty.” That is true, but not very helpful. What kind of uncertainty? After all, the world is always an uncertain place. Some types of uncertainty are linear and finite. For example, there’s always a lot of angst leading up to the monthly jobs report, as debate rages whether the number will exceed or miss estimates. But the point is that the number will be released, the market will quickly reprice, and the uncertainty will pass.
Other types of uncertainty are open-ended. The market became very nervous about the possibility of a global Ebola pandemic a few years ago, resulting in a 9 percent drop in U.S. equities, which in retrospect seems silly. Still, if you imagined the worst-case scenario, with millions of deaths and global commerce grinding to a halt, a 9 percent correction was probably warranted.
The stock market engages in what I like to call catastrophic thinking. Presented with any risk, it immediately imagines the worst-case scenario and quickly discounts it, which in market parlance means pricing it in. This is what is happening with trade and protectionism. The threat of protectionism is the number one driver of the downturn in equity markets because it’s such an open-ended risk. The market immediately goes to the worst-case scenario — U.S. President Donald Trump and China President Xi Jinping get into a game of one upmanship and raise tariffs and barriers to incredible heights, leading to a global recession — and discounts it.
If that scenario were to play out, it would mean that equity markets should probably be down 30 percent to 50 percent from the highs, and investors would discount that. But they may discount in error! If people on Wall Street really understood that Ebola is not such an easy disease to spread, especially in developed countries, they would have recognized a great buying opportunity. And maybe there are investors who think the market is wrong, and that Trump is bluffing on trade, like he usually does, and he will back away from his intransigence and strike a deal. It’s not so easy to do.
But as long as the risk is open-ended, the market discounting mechanism will go further out that binomial limb. Only once it appears that there will be closure — an agreement of some kind — will the discounting of the worst-case scenario stop. Until then, the breathtaking volatility that markets are experiencing will persist.
Whether risk is open-end or closed-end is often simply the product of someone’s imagination. There were a lot of risks in 2017 that the market simply ignored, like the threat of right-wing populism in Europe, conflict in Ukraine, North Korea, and Middle Eastern instability. Sometimes, like in 2018, investors are in the mood to worry about these sorts of things. In 2017, they were not. I am fond of saying: “It doesn’t matter until it matters.”
The markets are different than they were a couple of months ago. More volatile, yes, but anyone who spends most of their day staring at screens will tell you that the price action is different. Markets exhibit what I call nonstationarity — they are a game where the rules are constantly changing. The rules just massively changed. Investors must reinvent themselves or struggle mightily.
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