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The Big Short Vol

Raphael Fiorentino
23rd March 2020 - 6 min read

The abrupt and uninterrupted nature of the recent freefall in global growth expectations (see iGDP, our GDP index, momentum graph below) is starting to make 2008 look almost benign. For instance, our global financial stress index just spiked 16 standard deviations away from its 15-year mean, twice the 2008 peak level, even as central banks around the world have adopted a no-holds barred approach to prop up the reserves of financial institutions.

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Confidence and control are in short supply, as the balance sheets of G7 central banks look set to go from already 3.5 times their pre-2008 crisis levels at the start of 2020, to a multiple of that amount over the coming months. Government budget deficits are following suit. Meanwhile, the most crowded trade in history is unravelling in a self-reinforcing manner. Risk-parity, vol-targeting, (falsely liquid) indexing, (falsely active) fund managing, 60-40 robo-advising, tens of trillions of dollars that were all placed on the same (short) side of the (volatility) boat are being tipped overboard by a first wave of covid-19, further amplifying the resulting explosion of asset price, interest rate and currency volatility.

Never has so much debt fuelled so much financial return with such depressed volatility for so little growth

For the past decade central bankers proactively brought future asset returns into the present (ZIRP and QE), governments did the same with consumption (budget deficits), listed firms did the same with earnings per share (debt-financed share buy-backs), financial institutions levered up to find scraps of yield and investors piled up indiscriminately into equity (indices), safe in the knowledge that any dip would be promptly met by monetary and fiscal stimuli. With prospective growth and inflation looking more volatile than ever, and with large-scale recapitalisations on the horizon, the era of mindless passive investing is over. Should a recoupling of financial (equity) and real (commodity) asset prices occur, stockholders would stand to lose a further 60% from here (i.e over $35Tn). With over 90% of all listed equities having lost at least -15% of their value year to date, the correlations between all short vol assets turning positive, and the forced liquidation of long vol instruments like gold, there literally seems to be nowhere to hide.

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Never let a serious health crisis waste your economy

For all their cumulated deficits and three-fold increase in their share of GDP since the 19th Century, the best many Western Governments can do is go to war against a health crisis whose risk came to light weeks ago with quite pre-industrial and economically crippling measures. A swift and broad deployment of 21st century arsenals like those deployed in North-East Asia (targeted lockdowns, testing on an industrial scale, extensive use of mobile technology to trace and quarantine contacts of infected cases, mass distribution of infection prevention equipment and contagion reduction medicines, immediate ramp-up of medical care capacity, social distancing rules, etc.) might have quenched the initial outbreak within a few weeks, making it possible to manage contagion rates in a way that didn’t overwhelm our healthcare systems, and dramatically reduce prospective mortality rates (as observed in affected but still-in-business countries like South Korea and Taiwan). And so rather than short sharp drops in GDPs and contained volatilities of supply chain throughputs, we are faced with disruptions of unquantifiable extent and duration.

 

The “everything bail-out” plan to rescue the “everything bubble” era

In 2008, a housing crisis led central banks to bail-out financial institutions loaded with toxic debt by expanding their balance sheets by hundreds of billions of dollars. Today, they are committing tens of trillions of dollars to bail-out every shareholder and every creditor, ready to issue free indefinite loans for the face value of almost any collateral. The stock market may drop 10% one day and rise 20% the next following an intervention that eases US$ exchange rates or reins in corporate bond yields, only to close off completely days later for an indefinite period. It may be some time before we know the price and the value of anything.

 

Investing in a world of price and value uncertainty

With “top-down” considerations taking centre stage, we decided to upgrade the layout and content of the Markets section of the Butterwire platform, which compiles its global macro “nowcasting” insights and whose access now leads to 3 tabs:

  • The global macro tab regroups the existing information related to our global macro indicators (i.e. market-implied expectations of global growth-iGDP, monetary policy-iEMC, and price stability-iLCI).

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    We have added trend arrows to represent how much these indicators are moving daily. Also included in this tab are the tracking of stock returns according to their macro profile and the asset allocation graph as implied by the macro indicators.

    Daily trend of Butterwire’s global macro indicators (see arrows)

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  • The global equities tab consists of the markets breadth and returns skew graphs (stock-picking environment proxy) and the charts tracking technical break-up/break-down trends in regional indices as well as passive money flows

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    New charts have been added that track the % of exit? and take profit? alerts, highlighting situations when the downside risk of exit? stocks (over 13%) on the one hand, and the upside risk of take profit? stocks (over 4%) on the other hand, rise dramatically. As can be seen below, these percentage values shot up over December (ie. pre-covid-19), already signalling that something increasingly less stock-specific and increasingly more systemic was at play (i.e. lack of growth + tightening monetary policies, similar to end 2015 and end 2018).

    Monthly Average of Nr. Of “Exit?” Alerts and Nr. Of “Take Profit?” alerts (as % Nr. Of Stocks Covered)

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  • The global candidates tab first displays the levels of Butterwire’s “interesting candidates” indices relative to market benchmarks and to a random selection.

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    We have complemented this chart with “Interesting Stocks” Maps, as introduced in a previous note, to help quickly scan and a selection of stocks singled out by the engine for their likelihood of material future outperformance or underperformance.

 

“Don't listen to the person who has the answers; listen to the person who has the questions”

This Albert Einstein’s quote could just as well apply to investment AI/ML. When digital idiot-savants are relied upon to have the answers on forward-looking matters, based on vast amounts of backward-looking, insufficient (e.g. based on the past 10-30 years vs. the required 100-300 years), self-reflexive (e.g. sentiment analysis), and mostly non-significant (i.e. big) data, they reinforce lazy research, obliviousness to risk, and the effects of the Big Short Vol. Rather, Butterwire uses ML and Cloud computing to accelerate our own ability to surface the questions and perform more, better, faster and less heuristically-biased research.

The unfolding investment environment is reasserting the importance of top-down global macro considerations in bottom-up fundamental investing. It is also redefining what real diversification entails, as 60/40 portfolios make way to something that will maybe be more akin to 33/33/33 short vol/long vol/no vol ones. With “do-nothing” passive investing strategies turning into losing propositions, a return to truly active investing (i.e. concentrated portfolios of liquid individual securities selected for their fundamentals and together representing a high number of independent bets) could be in sight. This will however require active funds to deliver adequate active returns and to make a profit from much lower fees and a much smaller asset base. This in turn will require a step-change in their research productivity, starting with evolving their 20th Century research workbench (i.e. archaic trading terminal technology, lengthy brokers’ reports and error-prone excel spreadsheets) into the 21st Century (i.e. cleaned-up terminal data combined and distilled by insight-boosting Machine Learning/AI applications). Those who do so will both reduce research spend and start compounding a considerable competitive edge. Butterwire was conceived in similarly unsettling circumstances back in early 2009 to help address this exact productivity challenge and it was released in 2019 to help ease this very research workbench transition.