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Authored by Christopher Cole via Artemis Capital Management,

Volatility and the Alchemy of Risk

The Ouroboros, a Greek word meaning ‘tail devourer’, is the ancient symbol of a snake consuming its own body in perfect symmetry. The imagery of the Ouroboros evokes the infinite nature of creation from destruction. The sign appears across cultures and is an important icon in the esoteric tradition of Alchemy. Egyptian mystics first derived the symbol from a realphenomenon in nature. In extreme heat a snake,unable to self-regulateitsbody temperature,will experience an out-of-control spike in its metabolism. In a state of mania, the snake is unable to differentiate its own tail from its prey,and will attack itself, self-cannibalizing until it perishes. In nature and markets, when randomness self-organizes into too perfect symmetry, order becomes the source of chaos.

The Ouroboros is a metaphor for the financial alchemy driving the modern Bear Market in Fear. Volatility across asset classes is at multi-generational lows. A dangerous feedback loop now exists between ultra-low interest rates, debt expansion, asset volatility, and financial engineering that allocates risk based on that volatility. In this self-reflexive loop volatility can reinforce itself both lower and higher. In a market where stocks and bonds are both overvalued, financial alchemy is the only way to feed our global hunger for yield, until it kills the very system it is nourishing.

The Global Short Volatility trade now represents an estimated $2+ trillion in financial engineering strategies that simultaneously exert influence over, and are influenced by, stock market volatility. We broadly define the short volatility trade as any financial strategy that relies on the assumption of market stability to generate returns, while using volatility itself as an input for risk taking. Many popular institutional investment strategies, even if they are not explicitly shorting derivatives, generate excess returns from the same implicit risk factors as a portfolio of short optionality, and contain hidden fragility.  

Volatility is now an input for risk taking and the source of excess returns in the absence of value. Lower volatility is feeding into even lower volatility, in a self-perpetuating cycle, pushing variance to the zero bound. To the uninitiated this appears to be a magical formula to transmute ether into gold… volatility into riches… however financial alchemy is deceptive. Like a snake blind to the fact it is devouring its own body, the same factors that appear stabilizing can reverse into chaos. The danger is that the multi-trillion-dollar short volatility trade, in all its forms, will contribute to a violent feedback loop of higher volatility resulting in a hyper-crash. At that point the snake will die and there is no theoretical limit to how high volatility could go.

Thirty years ago to the day we experienced that moment. On October 19th, 1987 markets around the world crashed at record speed, including a -20% loss in the S&P 500 Index, and a spike to over 150% in volatility. Many forget that Black Monday occurred during a booming stock market, economic expansion, and rising interest rates. In retrospect, we blame portfolio insurance for creating a feedback loop that amplified losses. In this paper we will argue that rising inflation was the spark that ignited 1987 fire, while computer trading served as explosive nitroglycerin that amplified a normal fire into a cataclysmic conflagration. The multi-trillion-dollar short volatility trade, broadly defined in all its forms, can play a similar role today if inflation forces central banks to raise rates into any financial stress. Black Monday was the first modern crash driven by machine feedback loops, and it will not be the last.

A reflexivity demon is now stalking modern markets in the shadows of a false peace… and could emerge violently given a rise in interest rates. Non-linearity and feedback loops are difficult for the human mind to conceptualize and price. The markets are not correctly assessing the probability that volatility reaches new all-time lows in the short term (VIX<9), and new all-time highs in the long-term (VIX>80). Risk alone does not define consequences. A person can engage in highly risky behavior and survive, and alternatively a low risk activity can result in horrible outcomes. Those who defend and profit from the short volatility trade in its various forms ignore this fact.  Do not mistake outcomes for control… remember, There is no such thing as control… there are only probabilities.

The Great Snake of Risk

A short volatility risk derives small incremental gains on the assumption of stability in exchange for a substantial loss in the event of change. When volatility itself serves as a proxy to size this risk, stability reinforces itself until it becomes a source of instability. The investment ecosystem has effectively self-organized into one giant short volatility trade, a snake eating its own tail, nourishing itself from its own destruction. It may only take a rapid and unexpected increase in rates, or geopolitical shock, for the cycle to unwind violently. It is not wise to expect that central banks will save financial markets if inflation begins to rise.

At the head of the Great Snake of Risk is unprecedented monetary policy. Since 2009 Global Central Banks have pumped in $15 trillion in stimulus creating an imbalance in the investment demand for and supply of quality assets. Long term government bond yields are now the lowest levels in the history of human civilization dating back to 1285. As of this summer there was $9.5 trillion worth of negative yielding debt globally. Last month Austria issued a 100-year bond with a coupon of only 2.1%(6) that will lose close to half its value if interest rates rise 1% or more. The global demand for yield is now unmatched in human history. None of this makes sense outside a framework of financial repression. 

Amid this mania for investment, the stock market has begun self-cannibalizing… literally. Since 2009, US companies have spent a record $3.8 trillion on share buy-backs(7) financed by historic levels of debt issuance. Share buybacks are a form of financial alchemy that uses balance sheet leverage to reduce liquidity generating the illusion of growth. A shocking +40% of the earning-per-share growth and +30% of the stock market gains since 2009 are from share buy-backs. Absent this financial engineering we would already be in an earnings recession. Any strategy that systematically buys declines in markets is mathematically shorting volatility. To this effect, the trillions of dollars spent on share buybacks are equivalent to a giant short volatility position that enhances mean reversion. Every decline in markets is aggressively bought by the market itself, further lowing volatility. Stock price valuations are now at levels which in the past have preceded depressions including 1928, 1999, and 2007. The role of active investors is to find value, but when all asset classes are overvalued, the only way to survive is by using financial engineering to short volatility in some form.

Volatility as an asset class, both explicitly and implicitly, has been commoditized via financial engineering as an alternative form of yield. Most people think volatility is just about options, however many investment strategies create the profile of a short option via financial engineering. A long dated short option position receives an upfront yield for exposure to being short volatility, gamma, interest rates, and correlations. Many popular institutional investment strategies bear many, if not all, of these risks even if they are not explicitly shorting options. The short volatility trade, broadly defined in all its forms, includes up to $60 billion in strategies that are Explicitly short volatility by directly selling optionality, and a much larger $1.42 trillion of strategies that are Implicitly short volatility by replicating the exposures of a portfolio that is short optionality. Lower volatility begets lower volatility, rewarding strategies that systematically bet on market stability so they can make even bigger bets on that stability. Investors assume increasingly higher levels of risk betting on the status quo for yields that look attractive only in comparison to bad alternatives. The active investor that does his or her job by hedging risks underperforms the market. Responsible investors are driven out of business by reckless actors. In effect, the entire market converges to what professional option traders call a ‘naked short straddle’… a structure dangerously exposed to fragility.

Volatility is now at multi-generational lows…

Volatility is now the only undervalued asset class in the world. Equity and fixed income volatility are now at the lowest levels in financial history. The realized volatility of the S&P 500 Index collapsed to all-time lows in October 2017. The VIX index also touched new lows around the same time. Fixed income implied volatility fell to the lowest level in its 30year history this past summer. The forward variance swap on the S&P 500 index is now priced lower than the long-term average volatility of the market. In theory, volatility has nowhere to go but up, but lacks a catalyst given the easy credit conditions, low rates, and excess supply of investment capital.

Whenever volatility reaches a new low the financial media runs the same cliched story over and over with the following narrative 1) Volatility is low; 2) Investors are complacent; 3) Insert manager quote saying “this is the calm before the storm”. Low volatility does not predict higher volatility over shorter periods, in fact empirically the opposite has been true. Volatility tends to cluster in high and low regimes. 

Volatility isn’t broken, the market is…

…the real story of this market is not the level of volatility, but rather its highly unusual behavior. Volatility, both implied and realized, is mean reverting at the greatest level in the history of equity markets. Any short term jump in volatility mean reverts lower at unusual speed, as evidenced by volatility collapses after the June 2016 Brexit vote and November 2016 Trump US election victory. Volatility clustering month-to-month reached 90-year lows in the three years ending in 2015.

Implied volatility has also been usually reactive to the upside and downside. In 2017, the VIX index has been 3-4x more sensitive to movements in the market compared to the similar low-volatility regime of the mid-2000s and the mid-1990s (see red line in right chart).

What is causing this bizarre behavior? To find the truth we must challenge our perception of the problem… What we think we know about volatility is all wrong. Modern portfolio theory conceives volatility as an external measurement of the intrinsic risk of an asset. This highly flawed concept, widely taught in MBA and financial engineering programs, perceives volatility as an exogenous measurement of risk, ignoring its role as both a source of excess returns, and a direct influencer on risk itself. To this extent, portfolio theory evaluates volatility the same way a sports commentator sees hits, strikeouts, or shots on goal. Namely, a statistic measuring the past outcomes of a game to keep score, but existing externally from the game. The problem is volatility isn’t just keeping score, but is massively affecting the outcome of the game itself in real time. Volatility is now a player on the field. This critical mis-understanding of the role of volatility modern markets is a source of great self-reflexive risk. 

Today trillions of dollars in central bank stimulus, share buybacks, and systematic strategies are based on market volatility as a key decision metric for leverage. Central banks are now actively using volatility as an input for their decisions, and market algorithms are then self-organizing around the expectation of that input. The majority of active management strategies rely on some form of volatility for excess returns and to make leverage decisions. When volatility is no longer a measurement of risk, but rather the key input for risk taking, we enter a self-reflexive feedback loop. Low volatility reinforces lower volatility…  but any shock to the system will cause high volatility to reinforce higher volatility.

Self-Cannibalization of the Market via Share buybacks

The stock market is consuming itself…literally. Since 2009, US companies have spent over $3.8 trillion on what is effectively one giant leveraged short volatility position. Share buybacks in the current market have already surpassed previous highs reached before the 2008.

Rather than investing to increase earnings, managers simply issue debt at low rates to reduce the shares outstanding, artificially boosting earnings-per-share by increasing balance sheet risk, thereby increasing stock prices.

In 2015 and 2016 companies spent more than their entire annual operating earnings on share buybacks and dividends. Artemis isolated the impact of the share buyback phenomenon on earnings, asset prices, and valuations since 2009 and the numbers are staggering.

The later stages of the 2009-2017 bull market are a valuation illusion built on share buyback alchemy. Absent this accounting trick the S&P 500 index would already be in an earnings recession. Share buybacks have accounted for +40% of the total earning-per-share growth since 2009, and an astounding +72% of the earnings growth since 2012. Without share buybacks earnings-per-share would have grown just +7% since 2012, compared to +24%. Since 2009, an estimated +30% of the stock market gains are attributable to share buybacks. Without share buybacks the S&P 500 index would currently trade at an expensive 27x earnings. Not surprisingly, a recent study found a positive relationship between insider equity sales and share repurchases, supporting the idea that buybacks are more about managerial self-interest than shareholder value.

Share buybacks financed by debt issuance are a valuation magic trick. The technique optically reduces the price-to-earnings multiple (Market Value per Share/Earnings per Share) because the denominator doesn’t adjust for the reduced share count. The buyback phenomenon explains why the stock market can look fairly valued by the popular price-to-earnings ratio, while appearing dramatically overvalued by other metrics.  Valuation metrics less manipulated by share buybacks (EV/EBITDA, P/S, P/B, Cyclically Adjusted P/E) are at highs achieved before market crashes in 1928, 2000, and 2007. Buybacks also remove liquidity. Free float shares and trading volume in the S&P 500 index have collapsed to levels last seen in the late-1990s, despite stock prices more than doubling.

Share buybacks are a major contributor to the low volatility regime because a large price insensitive buyer is always ready to purchase the market on weakness.

The key periods are the two to three weeks during and after earnings announcements, when the SEC mandated share buyback blackout period officially ends. The largest equity drawdowns of the past few years (August 2015 and January-Feb 2016) both occurred during the share buyback blackout period. Both times the market rallied to make back all losses when the buyback restriction period expired. The S&P 500 index demonstrates an unusual multi-modal probability distribution during years with high buyback activity. The market flips between a positively or negatively skewed return distribution based on whether the regulatory share repurchase blackout period is in effect. In addition, 6 of the top 10 multi-day VIX declines in history, all 4+ sigma events, have occurred during heavy share buyback periods between 2015 and 2016. Share buybacks result in lower volatility, lower liquidity, which in turn incentivizes more share buybacks, further incentivizing passive and systematic strategies that are short volatility in all their forms. Like a snake eating its own tail, the market cannot rely on share buybacks indefinitely to nourish the illusion of growth. Rising corporate debt levels (see below) and higher interest rates are a catalyst for slowing down the $500-800 billion in annual share buybacks artificially supporting markets and suppressing volatility.

Global Short Volatility Trade

The short volatility trade is any strategy that derives small incremental gains on the assumption of stability in exchange for substantial loss in the event of change, whereby volatility is a critical input to the allocation of risk. Short volatility can be executed explicitly with options, or implicitly via financial engineering. To understand this concept, it is helpful to decompose the key risks. The investor holding a portfolio of hedged short options receives an upfront premium, or yield, in exchange for a non-linear risk profile to four key exposures 1) Rising Volatility; 2) Gamma or Jump Risk; 3) Rising Interest Rates; 4) Unstable Cross-Asset Correlations. Many institutional strategies derive excess returns by implicitly shorting those exact same risk factors despite never trading an option or VIX future.  As of 2017, there is an estimated $1.12 to 1.5 trillion USD(2) of active short volatility exposure in domestic equity markets.

In this paper we will focus on short volatility in US equity markets, however the short volatility trade, in all its forms, is widely practiced across all major asset classes. In world of ultra-low interest rates shorting volatility has become an alternative to fixed income. For the first time in history the yield earned on an explicit short volatility position is competitive with a wide array of sovereign and corporate debt (see below).

Explicit Short Volatility are strategies that literally sell options to generate yield from asset price stability or falling stock market variance. The category includes everything from popular short volatility exchange-traded-products to call and put writing programs employed by pension funds. Despite the headlines, this is the smallest portion of the short volatility trade. Explicit short volatility contains upward of only $60 billion in assets, including $45 billion in short volatility pension put and call writing strategies, $8 billion in short volatility overwriting funds, $2 billion in short volatility exchange traded products, and another $3 billion in speculative VIX shorts.  Explicit short volatility strategies are active in the short term, fading short and intermediate volatility spikes. Volatility spikes that mean revert quickly help the performance of these strategies (August 2015). Explicit short volatility is most harmed by an extended period of high volatility that fails to mean revert, such as in 1928 or 2008, or a super-normal volatility spikes such as the Black Monday 1987 crash.

Implicit Short Volatility are strategies that, although not directly selling options, use financial engineering to generate excess returns by exposure to the same risk factors as a short option portfolio. Many investors, and even practitioners, are ignorant or in denial that they are holding a synthetic short option in their portfolio. In current markets, there is an estimated $1.12 to $1.42 trillion in implicit short volatility exposure, including between $400 billion in volatility control funds, $400 to $600 billion in risk parity, $70-175 billion from long equity trend following strategies, and $250 billion in risk premia strategies. These strategies are similar to a short option position because they produce efficient gains most of the time, but are subject to non-linear losses based on variance, gamma, rates, or correlation change. The strategies tend to have longer time horizons for rebalancing than explicit short volatility. In practice, exposure to equities is reduced based on the accumulation of variance over one to three months. 

The next few pages will focus on some of the hidden risks in the short volatility trade, both explicitly and implicitly.

Gamma Risk

Imagine you are balancing a tall ruler vertically on your palm. As the ruler tilts in any one direction, you must to overcompensate in the same direction to keep to the ruler balanced. This is conceptually very similar to a trader hedging an option with high gamma risk. The trader must incrementally sell (or buy) more of the underlying at a non-linear pace to rehedge price fluctuations.

A short gamma risk profile is not unique to option selling, and is a hidden component of many institutional asset management products. The portfolio insurance strategy credited with causing the 1987 Black Monday Crash is a classic example of a short gamma profile gone awry. When large numbers of market participants are short gamma, implicitly or explicitly, the effect can reinforce price direction into periods of high turbulence. Risk parity, volatility targeting funds, and long equity trend following funds are all forced to de-leverage non-linearly into periods of rising volatility, hence they have synthetic gamma risk. At current risk levels, we estimate as much as $600 billion in selling pressure would emerge from implicit short gamma exposure if the market declined just -10% with higher vol. Many of these strategies rely on accumulation of one to three month realized variance to trigger that de-leveraging process. Hence the short gamma buying and selling pressure operates on a time lag to the market. During the drawdowns in the fall of 2015 and early-2016, share buybacks helped the market rebound quickly minimizing the effect of ‘short-gamma’’ de-leveraging. This further emboldened explicit short volatility traders to continue to fade any volatility spikes.

If the first leg of a crisis is strong enough to sustain a market loss beyond -10%, short-gamma de-leveraging will likely kick-start a second leg down, causing cascading losses for anyone that buys the dip. 

Correlation and Interest Rate Risk

The concept of diversification is the foundation of modern portfolio theory.  Like a wizard, the financial engineer is somehow able to magically reduce the risk of a portfolio by combining anti-correlated assets. The theory failed spectacularly in the 2008 crash when correlations converged. You can never destroy risk, only transmute it. All modern portfolio theory does is transfer price risk into hidden short correlation risk. There is nothing wrong with that, except for the fact it is not what many investors were told, or signed up for.

Correlation risk can be isolated and actively traded via options as source of excess returns. Volatility traders on a dispersion desk will explicitly short correlations by selling the variance of an index and going long the weighted variance of its constituents. When correlations are stable or decreasing, the strategy is very effective, but when correlations behave erratically large losses will occur. The graph to the right shows the collapse of correlations between normal and stressed markets. 

Many popular institutional investment strategies derive excess returns via implicit leveraged short correlation trades with hidden fragility

Risk parity is a popular institutional investment strategy with close to half a trillion dollars in exposure. The strategy allocates risk and leverage based on variance assuming stable correlations. To a volatility trader, risk parity looks like one big dispersion trading desk. The risk parity strategy, decomposed, is actually a portfolio of leveraged short correlation trades (alpha) layered on top of linear price exposure to the underlying assets (beta). The most important correlation relationship is between stocks and bonds. A levered short correlation trade between stocks and bonds has performed exceptionally well over the last two decades including in the last financial crisis. From 2008 to 2009 gains on bonds offset losses in the stock market as yields fell. To achieve a similar benefit in a crisis today, the 10-year Treasury Note would need to collapse to from 2.32% to -0.91%. This is not impossible, but historically there is a much higher probability that bonds and stocks rise or fall together when rates are this low.

The truth about the historical relationship between stocks and bonds over 100+ years is illuminating (please see our 2015 paper “Volatility and the Allegory of the Prisoner’s Dilemma” for more detail). Between 1883 and 2015 stocks and bonds spent more time moving in tandem (30% of the time) than they spent moving opposite one another (11% of the time). Stocks and bonds experienced extended periods of dual losses every 50 years.  It is only during the last two decades of falling rates, accommodative monetary policy, and globalization that we have seen an extraordinary period of anti-correlation emerge. At best the anticorrelation between stocks and bonds may cease to be a source of alpha, and at worst it may the driver of significant reflexive losses. 

Volatility Risk

With interest rates at all-time lows shorting volatility has become an alternative to fixed income for yield starved investors. The phenomenon is not new to Japan. For nearly two decades banks packaged and sold hidden short volatility exposure to Japanese retirees via wealth products called Uridashi. Uridashi notes pay a coupon well above the yield earned on Japanese debt based on knock-out and knock-in levels to the Nikkei index. In 2016 there was an estimated $13.2 billion USD in Uridashi issuance. Now that low rates are global the short volatility trade is expanding to retail investors beyond Japan.  In the US short volatility has emerged as a get-rich-quick scheme for many of these smaller investors. The short VIX exchange traded complex, at approximately $2 billion in listed assets, is the smallest but most wild segment of the global short volatility trade.  In the past you had to be a big Wall Street trading desk (‘Bear Stearns’) or hedge fund (“LTCM”) to blow yourself up shorting volatility. Not anymore. The emergence of listed VIX products democratized the trade. A story in the New York Times details the exploits of an ex-Target manager who made millions shorting a 2x leveraged VIX ETP. Such stories harken back to the dotcom bubble of the late 1990s when day-traders quit their jobs to flip internet stocks before the crash. 

When everyone is on one side of the volatility boat, it is much more likely to tip over. Short and leveraged volatility ETNs contain implied short gamma requiring them to buy (sell) a non-linear amount of VIX futures the more volatility rises (falls). The risk of a complete wipe out in the inverse-VIX complex in a single day is a very real possibility given the wrong shock (as Artemis first warned in 2015). The largest one day move in the VIX index was the +64% jump on February 27, 2007. If a similar move occurred today a liquidity gap would likely emerge.

The chart above estimates the volatility notional required for a +60% shock in the VIX given supply-demand dynamic over the past five years. For a +60% move in VIX we estimate ETPs would be required to buy $138 million in vega notional in the front two contracts alone, equivalent to 142k VIX contracts(12). This is over 100% of the average daily trading volume.  In this event, inverse-VIX products will experience an “unwind event” resulting in major losses for scores of retail investor. Those shorting leveraged VIX products will have unmeasurable losses. The products are a class-action lawsuit waiting to happen.

Shadow Risk in Passive Investing 

Peter Diamandis, the entrepreneur and founder of the X prize, said it best, “If you want to become a billionaire, find a way to help a billion people”. The purpose of efficient markets is to allocate capital to institutions that add the most value. In a market without value, the only thing left to do is to allocate based on liquidity. The massive stimulus provided by central banks resulted in the best risk-adjusted returns for passive investing in over 200 years between 2012 and 2015. Today investors are chasing that historical performance. By the start of 2018, 50% of the assets under management in the US will be passively managed according to Bernstein Research. Since the recession $2 trillion is assets have migrated from active to passive and momentum strategies according to JP Morgan.

Passive investing is now just a momentum play on liquidity.  Large capital flows into stocks occur for no reason other than the fact that they are highly liquid members of an index. All stocks in the index go up and down together, regardless of fundamentals. In effect, the volatility of the entire stock market can become dominated by a small number of companies and correlation relationships. For example, the top 10 stocks in the S&P 500 index, comprising only 2% of index membership, now control upward of 17% of the variance of the entire market. The largest 20 companies, or 4% of companies, are responsible for 24% of the variance.

The shift from active to passive investing is a significant amplifier of future volatility. Active managers serve as a volatility buffer, willing to step in and buy undervalued stocks when the market is falling, and sell overvalued stocks when the market is rising too much. Remove that buffer, and there is no incremental seller to control overvaluation on the way up, and no incremental buyer to stop a crash on the way down.

Shadow Risk in Machine Learning

Let’s pretend you are programmer using artificial intelligence (“AI”) to develop a self-driving car. You “train” the AI algorithm by driving the car thousands of miles through the desert. AI learns much faster than any human, so after a short period, the car able to drive at 120 miles per hour with perfect precision and safety. Now the car is ready for a cross-country trip. The self-driving car works flawlessly, driving with record speed through the city, desert, and flatlands. However, when it reaches the steep and twisting roads of the mountain the car drives right off a cliff and explodes. The fatal flaw is that your driving algorithm has never seen a mountain road. AI is always driving by looking in the rear-view mirror.

Markets are not a closed system. The rules change. As machines trade against machines, self-reflexivity risk is amplified. 90% of the world’s data across history has been generated over the last two years. It is very hard to find quality financial data at actionable time increments going back past 20 or even 10 years. Now what if we give all the available data, most of it extremely recent, to a machine to manage money? The AI machine will optimize to what has worked over that short data set, namely a massively leveraged short volatility trade. For this reason alone, expect at-least one major massive machine learning fund with excellent historical returns to fail spectacularly when the volatility regime shifts… This will be a canary in the coal mine.

Conceptual Mistakes in Shorting Volatility

“I can’t wait for the next crisis because I can sell volatility at even higher levels!” said one institutional asset manager at a conference. This is a commonly held but very dangerous assumption. Many investors compare shorting volatility to selling insurance. The option seller collects an upfront premium with frequent gains but large negative exposure to uncommon events. It is typical to erroneously conclude that selling volatility can never lose money if you keep systematically rolling the trade forward. The flaw in this logic is the assumption risk events are independent and probabilities consistent. In markets this is never the case.

Let’s play a game. You get to bet on a rigged coin with a 99% probability of landing on heads in your favor. If the coin lands on heads, you win +1% of your bankroll, but if it lands on tails, you lose -50%. Do you play? Yes, the game has a positive expected return, and given the law of large numbers you will always succeed if you keep playing. Consider that if the probabilities decrease to a 98% success rate, the game becomes a net loser. Remarkably, a 1% change in probability is the only thing that separates a highly profitable strategy from cataclysmic loss (see the statistics below). Small changes in probabilities have an outsized effect on the profitability of any strategy with small frequent gains and large infrequent losses.

The coin game is similar to a systematic short volatility strategy, except in life you never know which coin, positive or negative, you are betting on at any given time. Worse yet, in self-reflexive markets the probabilities between coin flips become correlated based on outcomes. For each loosing coin flip, the likelihood for another loss increases and vice versa! You start with 99% odds and a positive expected strategy, but after the first loss, the odds reduce to 90%. After two losses in ten, the odds fall to 50%.  It is not the first loss, or leg down in markets that hurts you, but rather the second and third. Systematic short volatility without accounting for shifting probabilities is akin to doubling down at a casino into bad odds. Don’t fool yourself… this is exactly how financial crises develop.

Shorting volatility, in of itself, is not necessarily a bad thing if executed thoughtfully at the right margin of safety. In our 2012 paper “Volatility at World’s End” we correctly argued, against our self-interest, for the overvaluation of portfolio insurance in what we coined a “Bull Market in Fear’ between 2009 and 2012. At the time tail risk hedging was very popular and investors shorting volatility had a high margin of safety.  For the reasons detailed in this paper, we believe the exact opposite today.

Intrinsic Value and Volatility

This past summer the ever-wise Jim Grant of Grant’s Interest Rate Observer asked for my thoughts on the low volatility regime. In the middle of my explanation on the short volatility trade, out of nowhere, Jim says, “What does any of this have to do with intrinsic value?” I was floored… I honestly didn’t know how to answer his question. The truth… the short volatility trade is about the absence of value. In a bull market, when investors can’t find value in traditional assets, they must manufacture yield through financial engineering. In a mania the system begins to devour its own tail.

The difference between risk and outcomes…

Imagine your friend invites you over for dinner. In his dining room is a barrel of highly explosive nitroglycerin.

You: “What is that barrel of explosive nitroglycerin doing in your living room!”

 

Friend: “Oh that, no big deal.” 

 

You: “It’s DANGEROUS! That could blow up the entire block!!! Where did you even get that?”

 

Friend: “Calm down,  the bank pays me good money to store it here, it’s the only way I can afford the mortgage."

 

You: “WHAT! ARE YOU CRAZY? All it takes is a small fire to set that thing off!”

 

Friend: “What fire? There is no fire. Look, it’s been here for five years without a problem.”

Risk alone does not guarantee any outcome, it only effects probabilities. The global short volatility trade, in all of its forms, is like a barrel of nitroglycerin sitting in the market portfolio. It may or may not explode. What we do know is that it can potentially amplify a routine fire into an explosion. The real question is what causes the fire?

The death of the snake…

Volatility fires almost always begin in the debt markets. Let’s start with what volatility really is. Volatility is the brother of credit…  and volatility regime shifts are driven by the credit cycle. Volatility is derived from an option on shareholder equity, but equity itself can be thought of as a perpetual option on the future success of a company. When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity less volatile, hence a tightening of credit conditions will lead to higher equity volatility. When credit is easily available and rates are low, volatility remains suppressed, but as credit contracts, volatility rises.

In the short term we do not see the credit stress required for a sustained expansion of volatility, but this can change very quickly. Storm clouds are gathering around 2018-2020, as rising interest rates, rich valuations, and corporate debt roll-overs all converge as potential triggers for higher stress and volatility. The IMF warned that 22% of U.S. corporations are at risk of default if interest rates rise. Median net debt across S&P 500 firms is close to a historic high at over 1.5x earnings, and interest coverage ratios have fallen sharply.  Between 2018-2019 an estimated $134 billion of high yield debt(16) must to be rolled-over, presenting a catalyst for higher volatility in the form of credit stress.

Reflexivity in the Shadow of Black Monday 1987

Thirty years ago, to the day, financial markets around the world crashed with volatility never seen before or equaled again in history. On October 19th, 1987 the Dow Jones Industrial Average fell more than -22%, doubling the worst day from the 1929 crash. $500 billion in market share vaporized overnight. Entire brokerage firms went bankrupt on margin calls as liquidity vanished. It was not a matter of prices falling, there were no prices. You couldn’t exit a position. Trading desks refused to pick up the phone. Black Monday appeared to come out of nowhere as it occurred in the middle of a multi-year bull market. There was no rational reason for the crash.  In retrospect, financial historians blame portfolio insurance, ignoring the role of interest rates, inflation, and the Federal Reserve. The demon of that day still haunts markets, and 30 years later the crash is still not well understood. Black Monday 1987 was the first post-modern hyper-crash driven by machine feedback loops, but it all started in a very traditional way.

Be careful what you wish for… Today every central bank in the world is trying to engineer inflation, but inflation was the hidden source of the 1987 financial crash. At the start of 1987 inflation was at 1.5%, which is lower than it is today! From 1985 and 1986 the Federal Reserve cut interest rates over 300 basis points to off-set a slowdown in growth. That didn’t last for long. Between January and October 1987 inflation violently rose 300 basis points. Nominal rates jumped even higher, as the 10-year US treasury rose 325 basis points from 6.98% in January 1987 to 10.23% by October 2014. The Fed tried to keep pace by raising rates throughout the year but it was not fast enough. The quick increase in inflation was blamed on the weak dollar, falling current account balance, and rising US debt-to-GDP levels. None of this hurt equity markets, as the stock market rose +37% through August 25th, 1987. Then the wheels fell off.

First the fire, then the blast…

In 1987 portfolio insurance was a popular strategy ($60 billion in assets) that involved selling incrementally greater amounts of index futures based on how far the markets fell (see short gamma risk above). The WSJ ran an article on October 12th that warned portfolio insurance “could snowball into a stunning rout for stocks”. Nobody paid attention.

Although equity markets continued to rise into the summer, the credit markets began to suffer from a liquidity squeeze.

The spread between interbank loans and Treasury Bills spiked 100 basis points in the month of September alone, and then rose another 50 basis points in October leading up to the crash. Corporate yields exploded 100 basis points the month leading up to the Black Monday crash, increasing of over 200 basis points since earlier in the year.  By the late summer the equity markets got the memo. Between August 25th and October 16th, the S&P 500 index fell 16.05%. S&P 100 volatility moved from 15 in August to 36.37 on October 16th.  That was just the beginning. 

On Black Monday the market lost one fifth of its value and volatility jumped to all-time highs of 150 (based on VXO index, predecessor to the VIX index). In total, from August to October 1987 the market lost -33% and volatility exploded an incredible +585%.

Black Monday is best understood as a massive explosion that occurred within a traditional fire. Rising inflation started a liquidity fire in credit, that spread to equities, and reached the nitroglycerin of computerized trading before exploding massively. Central bankers were not able to cut rates at the onset of the crisis to stop the fire due to rising inflation. The same set of drivers exist today, but on steroids. Higher rates combined with $1.5 trillion in selfreflexive investment strategies are a combustable mix. It is important to realize that the 1987 Black Monday crash was comparable to any other market sell-off until it wasn’t. The only difference… in 1987 volatility just kept going higher and markets lower. The chart above shows the movement in volatility leading up to crises in 1987, 1998, 2008, 2011, 2015. The point is that if you are a volatility short seller, how do you know whether you will get a 2015 outcome, when markets rallied, or a 1987 outcome? You don’t! In 1987 inflation started the volatility fire, but program trading amplified that fire into a cataclysmic conflagration. The $1.5 trillion short volatility trade, in all its forms, can play a very similar role now if rising inflation causes tighter credit conditions, but also limits central banks from reacting.

Melt-up Risk

Never underestimate the will of global central banks to risk overvaluation in asset prices to achieve inflation.  For this reason, a speculative melt-up in prices on par with the late 1990s dot-com bubble is possible if policy makers support markets perpetually amid low inflation and growth. In fact, one legitimate argument for raising rates is simply so they can lower them before the business cycle turns. High volatility and high equity returns often coincide in the final phases of a speculative market. Very few investors realize that between 1997 and 1999 the stock market experienced both rising volatility and returns at the same time.

For example, during this period the S&P 500 index was up close to +100% but with over five times the volatility we are experiencing today. The recent stock market bubble in China also was an example of high volatility and high returns. Yes, stocks are overvalued, but if rates stay low coupled with dovish monetary policy and supply-side tax reform it could touch a frenzy in speculation. For this reason alone, sitting on the sidelines presents business risk for professional managers.

How does an investor survive the Ouroboros?

The markets are not correctly assessing the probability that volatility reaches new all-time lows in short term (VIX <9 in 2017), and new all-time highs in the long term (VIX > 80 in 2018-2020) 

Reflexivity in both directions is very hard to conceive. Volatility is low and can go lower this year absent any catalyst. Rising interest rates, wage inflation, and credit issuance are very real catalysts in the long-term. Between 2018 and 2020 high yield issuers will re-test markets by rolling over $300 billion in expiring debt.

U.S. average hourly earnings are rising at fastest pace since pre-recession putting pressure on inflation. If these debt-roll overs occur into rising inflation and higher rates this could easily be the fire that sets off the global short volatility explosion. 

If you are going to short volatility, do it with a long-volatility mindset, namely a limited loss profile. Short-dated VIX put options that payoff with the VIX below 10 are currently 5-10 cents. Forward variance out one year is cheap and should be bought into any period of rising interest rates, inflation, or credit stress.

Fixed income volatility is at all-time lows at a time when the Federal Reserve is raising rates

Something must give, inflation or deflation, but you don’t have to be smart enough to know what if you bet on the volatility of fixed income.

Active Long Volatility and Stocks will outperform over the next five years

Long volatility is a bet on change, as opposed to direction. At a time when central banks are removing stimulus, the world has never been more leveraged to the status quo. For this reason, long volatility combined with traditional equity exposure is an effective portfolio for the new regime.  Historically a 50/50 combination of the CBOE Long Volatility Hedge Fund Index and the S&P 500 Index outperformed the average hedge fund by +97% since 2005. The inclusion of long volatility reduced equity drawdowns from -52% to -15% in 2008 while improving risk-adjusted returns. 

The value-add of active long volatility management is to minimize losses in stable markets while making portfolio changing returns in the event of a market crash. The smart long volatility fund can offer protection at a limited or even positive cost of carry.  The combination of active long volatility and equity has historically protected a portfolio from a deflationary crash like 2008, but can also profit if high volatility and high equity returns co-exist in melt-up like 1997-1999.  Long volatility may be your only line of defense if stock and bonds decline together. At this stage in the cycle, you want to position yourself on the other side of the global short volatility trade. 

*  *  *

Risk cannot be destroyed, it can only be shifted through time and redistributed in form. If you seek total control over risk, you will become its servant.

There is no such thing as control…

there are only probabilities.

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Teaching can be a thankless job.  Talk to almost any educator in the public school system and you’re bound to get a earful about grueling hours, disrespectful kids, infuriating bureaucracy and minimal pay.  As such, it looks increasingly like the teachers in Baltimore’s public schools have decided to just stop teaching altogether and pass every student that walks through their doors.

In the latest installment of a growing scandal revealed by “Project Baltimore”, an investigative reporting initiative launched by Sinclair Broadcast group in March 2017 to examine Baltimore’s public school system, a teacher at Calverton Elementary/Middle in west Baltimore has come forward with proof that grade changing is not only common in his school district but explicitly encouraged by senior administrators.

According to Fox45, below is the end of year text message that Calverton teachers received their principal, Martia Cooper, instructing them to “please double check end of the year averages and make sure they are 60 and above.”  The message went on to say that any “averages below 60” should be “corrected” so that failing students could be pushed through the system.

“Good Morning people! (Secretary) is printing report cards so finally you can get cumes finished. Please double check end of year averages and make sure they are 60 and above, except our four retention candidates (2 elem and 2 grade 7). If you find any grade averages below 60, pkesss (sic) have (secretary) correct and give me a copy of those student names. Thanks!”

The unidentified teacher who came forward to expose the text said it’s very clear what the intent of the message was.

A Calverton educator, who reached out to Fox45, claims to have received that text. “[It instructed me to] go into my grade book, make sure no students are failing, and essentially change the grade if they are failing so they will pass with a 60 percent,” said the teacher, whose identity we are concealing upon request.

 

“I was frustrated as a teacher. We’re public servants. And when we see things like grade changing, that’s self-serving. That’s not helping the kids.”

 

After watching Fox45’s recent investigations into allegations of grade changing at Calverton, the City Schools employee contacted Project Baltimore to say a couple things. First, according to the teacher, grade changing at Calverton is “very common.”

 

Second, the educator told Fox45, changing grades is the easiest and fastest way to pass more students, which makes the school and its administrators look better. But, it does a huge disservice to not just the kids, but our entire community.

 

“Teaching a whole generation of kids that they don’t have to be accountable for their actions, or that hard work isn’t valued or valuable when they are in school, is so discouraging and damaging.”

Adding insult to injury, the same teacher said that he even passed kids who had been on his roster all year but didn’t bother to show up for a single day of class.

But this teacher says grade changing at Calverton goes much further than just taking a failing grade and making it a 60. Some students who pass, according to this educator, don’t even have grades because they’ve never showed up to class.

 

“There were students on my roster all year that I had never met, had never seen. On paper they passed my class and passed onto the next year.”

 

“I love my job and I love my students,” concluded the teacher. “I want to see the students at Calverton and other schools across the city, get a fresh start. And it’s going to be hard because the students are used to this now. But the students deserve better and our city deserve better.”

Makes you wonder what those “four retention candidates (2 elem and 2 grade 7)” from the principals text above had to do to actually fail a grade.

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Authored by Jeremiah Johnson (nom de plume of a retired Green Beret of the United States Army Special Forces) via SHTFplan.com,

The United States (and the world) has been using the worthless fiat federal reserve note that is not backed by any true tangible asset.  The only backing is not even the “full faith and credit of the United States government,” because the government is too far in debt to have any credit.  Faith disappeared a long time ago: our faith in elected officials as public servants.  Instead, they serve themselves upon the labors of the public, and the public services them, in every sense of the word.

Cryptocurrency is an illusion.  The new “shell game” is to replace one illusion…the fiat currency…with another illusion, the “bitcoin.” 

Russia announced last week several measures to “deal” with the Cryptocurrency…first, by issuing a Crypto-ruble.  If you read the fine print, the Russian government is moving in to tax and regulate it, at a rate of 13% on trades for profit, as well as “Crypto-Rubles” that suddenly appear out of nowhere.

It won’t affect the Black Market as much, because 13% is going to be paid to turn a blind eye to the billions of rubles being stolen by the Russian Mafia and oligarchy alike.  The gimmick here is for the government to take a chunk out of it: for now.  The reason “now” is being used, is that eventually they’ll shift gears, pass legislation, and eventually outlaw private trading in it that is not government-sanctioned or government-approved.

A government is only concerned with perpetuating itself and maintaining power.  The most basic way it does this is by controlling the currency of the nation, regulating it, and taxing the citizens.  In the United States, it has been reported by several sources that JP Morgan Chase is going to embrace Cryptocurrency.  Europe is well on its way to establishing a “Euro-BitCoin,” and China has recently relaxed some measures regarding it.

This is the calm before the storm: the governments are studying it, and studying the masses to find the means to take control of it.

The gullible masses are playing right into their hands.  The problem with Cryptocurrency is not just in the fact that it is backed by nothing (a fool’s errand before it has been started), but there is no privacy.  None.  If the governments control and monitor all electronic and computer media, then there is no such thing as privacy regarding electronic currency.  This will be the death of cash, and thus the death of any privacy for citizens.

There will be no hiding from the taxing authorities.  All the accounts will be monitored: taxed on any growth, and every single penny accounted for.  The government will know what work you do, for how much, and how much “Crypto-currency” you have in your accounts.  All electronic, nebulous, unbacked garbage.  How about a nice “glitch” where suddenly, your entire account falls to a zero balance?  That “glitch” can happen anytime.

No, the politicians and the oligarchs will have gold, silver, real estate, mining rights and contracts, and ownership of every utility and municipal function upon which the public is dependent.  Eventually the Crypto-Dollars will be handed out sparingly to “exchange for food, clothing, and to pay their bills,” and the whole thing is designed for one thing:

To keep the population at a starveling, subsistence level while those in power own everything, and them as well: Ruled by the politicians and oligarchs, fooled by the press and the religious pulpits, and killed by the enforcement arms of police and military.

In 1910, the meeting on Jekyll Island, Georgia took place leading up to 1913.  It was then that the framework for the transfer of the power of the U.S. government over the nation’s currency to the federal reserve was established.

“The real truth of the matter is, as you and I know, that a financial element in the larger centers has owned the Government ever since the days of Andrew Jackson.”

 

President Franklin D. Roosevelt’s letter to Colonel Edward Mandell House,

Fmr. Advisor to President Woodrow Wilson    November 21, 1933

The aim is global governance.  The Cryptocurrencies arose out of a desire to use something other than the dollar and other failing fiat notes not backed by anything.  The irony is that the Cryptocurrencies are the vehicle for the globalists.

Once each nation has its Cryptocurrencies in place, they can “align” them, and virtually abolish all economic buffers and barriers…which will come crashing down just as the illegal aliens in Europe and the United States are destroying the borders, language, culture, and societies.  The whole thing is trumpeted as a recourse, but it is nothing more than an extension of an Alinsky principle “organizing the organized.”  At the right moment, the governments will swoop in, regulate, and tax these Cryptocurrencies.

Once cash is eliminated, hard assets such as gold, silver, and other resources will be simple to control.  Where did you obtain that gold?  How did you obtain it, and is it in our records?

The power lies in the receipt, the payment receipt showing where you obtained that product and how you obtained it…all based on POS (point of sale), the electronic monitoring of every expenditure at the register.  The “successful” employment of Cryptocurrency will mean that the people have been completely duped and have handed all privacy into the control of the government.  Once they control everyone economically, they will use that control to seize other aspects of daily life that are not regulated.  They’ll know how much you make, where you work, and how much you have available.

Or what you think you have available, because in the blink of an eye, they’ll make your Crypto dollars disappear, and you’ll have no recourse, just as they have no accountability.  If politicians steal money now, while cash still exists, think of how much they’ll be able to steal when everything is done electronically…when all the bankers and oligarchs are under their control/in a symbiotic-parasitic relationship and they can pass any law they wish.  Cryptocurrency is a scam that will eventually lead to the final enslavement of the U.S.

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Democratic megadonor and ‘enlightened plutocrat’ Tom Steyer can no longer sit idly by and watch as President Donald Trump sullies the dignity of the Oval Office by lashing at anybody who criticizes him and issuing Twitter rants directed at enemies both real and perceived.

So he's decided to do something about it by releasing a laughably sanctimonious new video framed as a call to arms for Republican members of Congress to “do what’s right” and “demand that members of Congress take a stand on impeachment" of President Trump.

In the hilarious video, Steyer accuses Trump of being “mentally unstable” while simultaneously alleging that he’s brought the US to the brink of nuclear war to indulge his own ego. Steyer’s litany of distorted accusations – from accepting bribes from foreign governments to deliberately obstructing justice – combined with saccharinely somber background music makes for an obliviously un-self aware attempt at emphasizing the 'gravity' of the situation.

“A Republican Congress once impeached a president for far less, yet today people in this Congress know that the president is a clear and present danger armed with nuclear weapons…and they do nothing."

And in what’s perhaps the coup de grace, Steyer bills himself as an “American Citizen” (of course, we can think of a few more precise labels that might be more appropriate).

Steyer is the founder of investment firm Farallon Capital and the NextGen America environmental political action committee, which opposes the controversial Keystone XL pipeline.

While Steyer’s push will likely fall on deaf ears given the Republican majorities in both houses of Congress, impeachment is hardly the biggest threat to Trump’s presidency. As Steve Bannon once reportedly informed a surprised Trump, a clause of the twenty fifth amendment that allows the president’s cabinet to vote to strip the president of his office is much more concerning – particularly given the Republican establishment’s embrace of vice president Mike Pence.

Predictit shows the odds of a Trump impeachment have been relatively stable in recent months at around 30% – though low trading volume raises questions about the validity of this number.

In either case, Steyer has joined a handful of wealthy Americans who are actively campaigning against president Trump. As Russia Today points out, ‘porn king’ Larry Flynt earlier this month offered $10 million for any information that would help to remove Trump, whom he referred to as “a moron” from the White House.

Steyer and Flynt’s denunciations of the Trump administration are indicative of a glaring inconsistency in the so-called resistance’s criticisms of Trump: The president is both a calculating and dangerous leader, and a doddering incompetent moron.

So which is it?

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Last weekend, as Deutsche Bank’s derivatives strategist Aleksandar Kocic was looking at the spread between the short and long end of the curve, and while contemplating the lack of market volatility, he concluded that “given where long rates are, Fed appears as overly hawkish – it has only two more hikes to go and, for volatility and risk premia to reprice higher, the gap has to widen. As is appears unlikely that the Fed will be cutting rates any time soon, the gap could widen only if the Long rates sell off.” In practical terms – if only for bond traders – this meant that “for anything to happen, 5Y5Y sector has to move higher”, however the $6.4 trillion question is whether this sell off in long rates will be violent or controlled. As Kocic concluded, “This is the catalyst for everything.”

In other words, those lamenting the pervasive complacency and the ubiquitous lack of volatility in the market, may not have much more to wait: after just two more rate hikes, absent a parallel move wider across the rest of the curve, the Fed’s “breathing space” will collapse, and Yellen, or rather her successor, will lost control of both vol markets and long-dated yields, as the Fed effectively hikes into a self-made recession, where it itself inverts the yield curve. That would be a problem.

Incidentally, among Wall Street’s rates and derivatives strateigsts, the mixed – and polar opposite – signals being sent by the rates market has been all the rage in recent weeks, and everyone is eager to explain what happens next. For those who are unfamiliar, the conflicting dynamic sent by the bond curve is that “while the short end is optimistic, the long end has never been more pessimistic”, in the words of BofA’s rates strategist Shyam Rajan. And yet, in a paradoxical feedback loop, rarely has the near term meant more to the long term than today.

Here is how Rajan summarizes the “two-faced rates market”, in which the 2s10s is so flat it is a clear warning that all else equal, a recession is approaching:

The rates market is sending diametrically opposite messages over the last few weeks. The front of the curve is increasingly confident about a Fed that will hike not only in December but at-least two more times next year. But, the flattening in the intermediate to long end of the curve is sending a clear end of business cycle message.

To say the least this is painfully confusing, because while the two can be squared off with a “hawkish policy mistake” message, “such an interpretation would not be consistent with the stock market reaching new highs or the dollar largely moving sideways this month” according to Rajan.

 

It’s not just equities whose all time highs make no sense in light of this paradox: There is another notable problem with these divergent views about the future sent by the yield curve: 

The problem with this disconnect in our view, is that rarely has the longer term outlook been more dependent on the short term – in fact, the next three months will provide us clarity on 1) The ability of Congress to muster the votes on the budget resolution and the possible tax reform bill 2) The outcome of the looming government shutdown on Dec 8 – and the possible leverage used by both the President and the Democrats over this key event risk 3) The geopolitical tension between US and North Korea aka the outcome of the key game of chicken outlined in this Cause and Effect.

The silver lining is that all of the above triggers – which are all critical regimes changers – will be unveiled soon enough:

Unlike economic data which has only a near term impact, the above three all have the potential to be regime switchers – tax reform moves us from a low r* to possibly higher r* world, geopolitics from low vol to high vol, and government shutdown from partisan politics to bipartisanship. Ultimately, we find it hard to believe that a Fed that is closer to its “perceived” neutral rate would hike several times before having some evidence that the neutral rate itself or inflation is going higher.

 

… Unless of course, the Fed is no longer concerned about the economic consequences from its actions, but merely eager to burst the stock market bubble, in which case should Yellen (or Powell, or Warsh, or Taylor) keep hiking until it inverts the curve, volatility is set to explode.

Which, incidentally, brings us to the latest note from DB’s derivatives expert, Aleks Kocic, who picks up on his note from last week, which as we pointed out last week highlighted that the Fed has 2 (at most 3) more rate hikes before it loses control. In logical continuation, Kocic asks “How much more can the curve flatten?” Here is his answer:

Although economic and political reality has not been lacking in excitement, the underlying uncertainties do not seem to convert into market volatility. Depressed long rates remain hostage to the long-term secular trends like demographics, global demand and potential growth, which is constricting the maneuvering space and gradually extinguishing risk premia across all market sectors. In rates, the playground defined by the gap between the long rate and near-term Fed expectations has shrunk to about 60bp. This means that there is room to price only two more hikes beyond what is already in the curve. The tightness of this gap is a function of the risk distribution which is forcing a gradual, but persistent, Fed.

 

In our view, the only way volatility and risk premia can return to the markets is if long rates sell off and free some room for the rest of the curve to start moving. The figure shows the history of the long rate and short term Fed expectations (Target or the Shadow rate) as extracted by our affine model. The long rate defines the upper bound for rate hikes.”

Kocic concludes that exceeding this boundary “leads to unsustainable inversions of the curve. By hiking beyond long rates, Fed would stifle growth and reduce inflation expectations which would encourage the savings rate and withdraw consumption and investment.” In short, the Fed could – and maybe would – cause a recession: 

Overly flat or inverted curve inhibits credit disintermediation and generally inspires forces that go against it. Investors are incentivized to borrow (and therefore pay) long term and deposit short term and receive higher rate,which tends to steepen the curve. In addition, in flat curve environment, lenders are reluctant to engage which would widen the spreads. In response, either the Fed cuts rates as a stimulus, or the curve itself bear steepens

Which, in turn, goes back to what we wrote over a month ago when we described what the real “$2.5 Trillion Question” is:

Is the Fed now actively seeking to launch the next recession (under president Donald Trump no less)? Perversely, it would make a lot of sense: with the business cycle now broken as a result of so much undue implicit reliance on asset prices, all of which are in a bubble – something which the Fed also understands – it would be beautifully symmetric that the same agent, the US Federal Reserve, that broke the business cycle and unleashed one of the longest, if artificial and on the back of trillions in central bank liquidity, economic expansion is now eager (and hoping) to be the catalyst for the next recession.

 

Or said simply, is the Fed now eager to accelerate the next economic recession in order to undo its own damage to a business cycle which has forgotten there should also be a contraction?

One month later, this remains the real $2.5 trillion question. No wonder everyone, not just bond traders, is so confused…

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With Spain officially pulling the trigger on Article 155, and activating the Spanish Constitutional “nuclear option” this morning, when PM Rajoy said he would seize control of the Catalan government, fire everyone and force new elections in six months, attention has shifted to the Catalan response. And as we waited for the official statement by Catalan separatist president Carles Puigdemont, expected at 9pm local time, we found him taking to the streets, where he led hundreds of thousands of independence supporters in protest around Barcelona on Saturday, shouting “freedom” and “independence” following the stunning news from Madrid earlier on Saturday.

The protest in the center of the Catalan capital had initially been called to push for the release of the leaders of two hugely influential grassroots independence organisations, accused of sedition and jailed pending further investigation. But it took on an even angrier tone after Prime Minister Mariano Rajoy announced his government would move to dismiss the region’s separatist government, take control of its ministries and call fresh elections in Catalonia.

According to municipal police, over 450,000 people rallied on Barcelona’s expansive Paseo de Gracia boulevard, spilling over on to nearby streets, many holding Catalonia’s yellow, red and blue Estelada separatist flag.

Catalan regional vice-president Oriol Junqueras and Catalan regional president
Carles Puigdemont attend a demonstration on October 21, 2017 in Barcelona

Protesters greeted Puigdemont’s arrival at the rally with shouts of
“President, President.” The rest of his executive was also there.

For at least some locals, the time to split from Spain has come: “It’s time to declare independence,” said Jordi Balta, a 28-year-old stationery shop employee quoted by AFP, adding there was no longer any room for dialogue.

Others disgree: “The Catalans are completely disconnected from Spanish institutions, and particularly anything to do with the Spanish state,” said Ramon Millol, a 45-year-old mechanic.

Meritxell Agut, a 22-year-old bank worker, said she was “completely outraged and really sad.” “They can destroy the government, they can destroy everything they want but we’ll keep on fighting.”

Catalonia is roughly split down the middle on independence, but residents cherish the autonomy of the wealthy, northeastern region, which saw its powers taken away under the dictatorship of General Francisco Franco. Which is why, as many have warned, Madrid’s move could anger even those against independence.

Barcelona’s Mayor Ada Colau, who opposes the independence drive, tweeted: “Rajoy has suspended the self-government of Catalonia for which so many people fought. A serious attack on the rights and freedoms of everyone.”

Meanwhile, the anger keeps rising: as a police helicopter hovered above, protesters booed and gave it the finger. “I wish they would just go,” said Balta, looking up at the sky.

The Spanish government’s proposed measures still have to be approved by the Senate. But the upper house is majority-controlled by Rajoy’s ruling Popular Party and he has secured the support of other major parties, meaning they will almost certainly go through.

Puigdemont is expected to make a statement at 9 p.m. For Catalonia, and Spain, it will – literally – mean the difference between independence and remaining part of Spain. It could also mean the difference between peace and a violent crackdown by Madrid on what it has seen since day one as an illegal independence process. For the Catalan leader, the stakes are huge:  El Pais reported Puigdemont faces a charge of sedition, punishable by up to 30 years in prison, if he formally declares independence or tries to change the Spanish constitution.

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'Speculators' have never been so confidently complacent that 'all is well'.

Speculative positioning in VIX futures and options remains at its most short in history as traders refuse to back away from 'what works' as realized volatility collapses to its lowest in over 60 years…

And as Dana Lyons notes, assets in mutual funds designed to rise when stocks fall have dropped to an all-time low.

In the Northern hemisphere here, bears typically begin their hibernation stage in November-December. However, that process has begun early this year for some bears on Wall Street. Specifically, traders of the Guggenheim (formerly Rydex) group of inverse mutual funds are showing very little sign of life at the moment. We say that due to the fact that assets in such funds have shrunk to their lowest level in history.

We’ve covered this data on multiple occasions in the past, as we have found it to be a helpful read on investor sentiment. Unfortunately (perhaps) for bulls right now, this data, like most sentiment related indicators, has worked best in a contrarian manner. From a TLS post last March, this section is still applicable:

Inverse funds, or bear funds, are of course designed to rise when stocks fall. Rydex originally introduced these funds for active traders to utilize in playing the downside in the stock market, or hedging. Like most sentiment measures, assets in these bear funds typically hit contrary extremes at turning points in the market, i.e., assets soar near market bottoms and plunge at tops. (Note: for purposes of this study, we are using the combined assets of the most popular 1X and 2X inverse S&P 500, Nasdaq 100 and Russell 2000 funds).

Now, as anyone familiar with the topic knows, mutual fund assets, in general, have been in a structural decline for about 10 years coinciding with the proliferation of ETF’s. Even so, the level in bull and bear assets have continued to cycle within shorter time frames with the ebbs and flows of the market.

For example, during the 2015-2016 stock market decline, bearish assets jumped from an all-time low around $126 million near the May 2015 top to nearly $500 near the February 2016 market low. Therefore, while mutual fund assets are in a structural decline, in general, their current all-time low level around $111 million should still be considered an extreme relative to the recent period.

That said, we will say the new low does not automatically suggest the top must be at hand. For one, given the fact that the market is at or near all-time highs, we shouldn’t be surprised that bear assets are at an all-time low. In fact, we should rather expect it. That is how sentiment-based flows work. Furthermore, there is no law saying bearish fund assets can’t go even lower, i.e., the extreme can get more extreme. In that last cycle, bearish assets dropped to a new low in early December 2014 but did not bottom out (along with the stock market top) for another 5 months.

Perhaps the best takeaway of this data point is as a measurement of potential risk. That is how we often like to think of sentiment indicators. In other words, if the stock market were to experience a selloff, how much potential downside might there be? Of course, there are countless factors that go into such a consideration; however, the potential risk based just on this bearish fund asset indicator is substantial. If, for example, assets were to simply mean revert close to that $500, or even $400, million mark, odds are very good that the move would be associated with a significant pullback in stocks. Considering how low assets are now, it would likely take either a serious and/or extended decline to spur the accumulation of so many bearish fund assets.

In summary, we are not calling for the end of the rally based on this indicator of bearish fund assets. Sentiment is not a timing tool and the indicator can get even more extreme in its scarcity. However, we would consider it a sign of significant potential risk should the market turn lower given the traders’ lack of hedging and ability to withstand much downside currently.

*  *  *

This is a free look at the “all-access” versions of our charts and research that we post daily (among much more) on our new site, The Lyons Share. TLS is currently running a 30th anniversary 1987 Crash Commemoration SALE, offering a discount of 22.6%, or the equivalent of the Dow’s 1-day drop 30 years ago. The SALE ends October 22 so considering the discounted cost and a potentially frothy market climate, there has never been a better time to reap the benefits of our risk-managed approach. Thanks for reading!

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Freed of any need to be marginally politically-correct, former Trump chief strategist Steve Bannon took his fight to the Republican establishment during a speech to a capacity crowd at an almost oxymoronic California Republican Party convention.

The ubiquitous protesters were there…

But were kept behind steel barricades on a plaza across an entrance road at the hotel and no arrests were made, as Bannon blasted former President George W. Bush for 'embarrassing himself' for his comments suggesting a Trump America led to 'nativism' and 'casual cruelty.'

Bannon said Bush has no idea whether “he is coming or going, just like it was when he was president.”

“There has not been a more destructive presidency than George Bush’s,” Bannon added, as boos could be heard in the crowd at the mention of Bush’s name.

As AP reports, the remarks came during a speech thick with attacks on the Washington status quo, echoing his call for an “open revolt” against establishment Republicans.

He called the “permanent political class” one of the great dangers faced by the country.

Bannon said that while John Mccain 'deserves our respect, as a politician, he's just another Senator from Arizona.'

Bannon also took aim at the Silicon Valley and its 'lords of technology,' predicting that tech leaders and progressives in the state would try to secede from the union in 10 to 15 years. He called the threat to break up the nation a 'living problem.'

Bannon also argued that the coalition that sent Trump to the White House, including conservatives, Libertarians, populists, economic nationalists, evangelicals, could hold power for decades if they stay unified.

“If you have the wisdom, the strength, the tenacity, to hold that coalition together, we will govern for 50 to 75 years,” he said.

He also tried to cheer long-suffering California Republicans, in a state that Trump lost by over 4 million votes and where Republicans have become largely irrelevant in state politics.

In Orange County, where the convention was held, several Republican House members are trying to hold onto their seats in districts carried by Hillary Clinton in the 2016 presidential contest.

'You've got everything you need to win,' he told them.

He ended his speech with a standing ovation.

Bannon is promoting a field of primary challengers to take on incumbent Republicans in Congress. But in California, the GOP has been fading for years. Republicans are now a minor party in many California congressional districts, outnumbered by Democrats and independents. Statewide, Democrats count 3.7 million more voters than the GOP.

Not all Republicans were glad to see Bannon though. In a series of tweets last week, former state Assembly Republican leader Chad Mayes said he was shocked by the decision to have the conservative firebrand headline the event.

“It’s a huge step backward and demonstrates that the party remains tone deaf,” Mayes tweeted.

As AP concluded, California Republicans have bickered for years over what direction to turn – toward the political center or to the right.

'Steve Bannon is a natural fit for a party that is hungry for a revolution, and the party in California is definitely hungry for a revolution,' former Orange County Republican leader Scott Baugh said.

via http://ift.tt/2guE2nE Tyler Durden