Two weeks ago, we discussed the recent report from Artemis Capital Management, “Volatility and the Alchemy of Risk – Reflexivity in the Shadows of Black Monday 1987”, authored by Christopher Cole. See “In the Shadows Of Black Monday – “Volatility Isn’t Broken…The Market Is”. The full report can be accessed here.

Perhaps because we posted it on a weekend, we feel that this must read report – one of the best reports we’ve read in years - has not received the profile it deserves. We think that it’s important to highlight it again, as it explains the mechanics which are likely to drive the next financial crisis. We begin with a ten bullet point summary.

In the Global Short Volatility Bubble:

• We are in an unprecedented bear market in fear, i.e. falling volatility, thanks to the unconventional monetary policies of central banks;
• Instead of being an external measure of risk, volatility has become a tradeable input – making it reflexive in nature;
• As volatility falls, investors (using leverage) take bigger bets in the same direction, so lower volatility begets lower volatility.
• The global short volatility trade is more than $2 trillion;
• It consists of explicit short volatility trades and implicit short volatility trades, e.g. risk parity and accumulated equity share buybacks (price insensitive/buy the dip);
• Due to reflexivity, in any shock to the system which starts an unwind in the global short volatility trade, higher volatility will reinforce higher volatility;
• The markets are effectively converging into what’s known in option markets as a ‘naked short straddle’ – as volatility declines, the upfront premium (yield) declines while non-linear risk rises;
• Non-linear risk has four components - rising volatility, gamma risk, unstable cross-asset correlations and rising interest rates;
• Volatility is the most undervalued asset class in the world;
• The unwind of the global short volatility trade would lead to a sudden hyper-crash, similar but worse than 1987.

It’s become fairly common for the current central bank-created bubble in financial markets to be labelled the “Everything Bubble”. We can’t remember who coined the phrase, it might have been John Hussman, who describes current financial conditions as “the most broadly overvalued moment in market history”. No matter, here is one representation from the portfolio managers at Incrementum AG.

However, when you think about the markets in holistic fashion, there is no way that this is the “Everything Bubble”. It can’t be when some asset classes – and precious metals and many commodities immediately spring to mind – are far from all-time highs. Gold, especially, stands out, being a financial asset.

As keen students of the esoteric in markets and literature, we’ve found a kindred spirit in Artemis’s Christopher Cole. Cole refers to alchemy in the context of the ouroboros – the snake devouring its own tail. Besides demonstrating an understanding of true alchemy, rather than the profane, Cole uses the ouroboros as a metaphor for today’s central bank-driven financial markets. In Cole’s opinion, the financial markets are in the process of self-cannibalizing and, as he posits.

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.

This is not an “Everything Bubble” but, in our opinion, a multi-trillion dollar global short volatility bubble (GSVB). This is Cole's description.

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.

Cole explains how the GSVB developed via the long-term bear market in volatility.

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…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% 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.

Within a background of extreme central bank intervention, the GSVB is a complex animal consisting of three main pillars.

• Explicit Short Volatility – includes short volatility ETFs, VIX shorts, pension fund call and put writing;
• Implicit Short Volatility – includes volatility control funds, risk parity, long equity trend following, risk premia strategies; and
• Share buybacks in equity markets.

While there are explicitly short volatility strategies, strategies which are implicitly short volatility are bigger by magnitudes (think risk parity, for example) and this is what the vast majority of investors and market commentators are failing to appreciate - Cole explains.

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.

Besides explicitly and implicitly short volatility strategies, the $3.8 trillion of US share buybacks has grown into another under-appreciated pillar of the GSVB. In part, this is due to its BTFD characteristic.

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 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…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.

As Cole explains, the financial markets are, in practice, converging towards what is known as a naked short straddle in option markets.

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.

If you are unfamiliar with the term, Investopedia has this to say about naked short straddles.

A short straddle is an options strategy carried out by holding a short position in both a call and a put that have the same strike price and expiration date. The maximum profit is the amount of premium collected by writing the options. If a trader writes a straddle with a strike price of $25 and the price of the stock jumps up to $50, the trader would be obligated to sell the stock for $25. If the investor did not hold the underlying stock, he or she would be forced to buy it on the market for $50 and sell it for $25. The short straddle is a risky strategy an investor uses when he or she believes that a stock's price will not move up or down significantly. Because of its riskiness, the short straddle should be employed only by advanced traders due to the unlimited amount of risk associated with a very large move up or down.

As Cole notes.

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.

In effect, as volatility declines and the upfront premium, or yield, declines, non-linear risk rises. The rise in non-linear risk has four components.

1. Rising volatility;
2. Gamma or Jump Risk;
3. Unstable Cross-Asset Correlations; and
4. Rising Interest Rates.

Let’s deal with each one as briefly as possible. With volatility at multi-generation lows and the pervasiveness of the GSVB across multiple asset classes, Cole’s argues that.

Volatility is now the only undervalued asset class in the world.

While we might disagree that volatility is the only undervalued asset class, we know where he’s coming from. We do agree with Cole’s assertion that.

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.

Why is this? Cole explains that the mainstream understanding of volatility is incorrect. i.e. instead of being an exogenous measure of risk, it is a tradeable input. Given the existence of the vast explicit and implicit short trades in volatility, we are once again back in the realm of reflexivity and the snake devouring its own tail.

…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 misunderstanding 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…Low volatility reinforces lower volatility…but any shock to the system will cause high volatility to reinforce higher volatility.

The point about gamma risk is the need to sell/buy more of an underlying asset “at a non-linear pace to re-hedge price fluctuations” in the underlying asset. Cole likens the risk in today’s markets with what happened during the Crash of 1987. Back then, it was the portfolio insurance strategy which accelerated the selling as stock prices fell. As Cole notes.

“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.

Given the BTFD of the current bull market, the following point from Cole deserves emphasis.

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.

Having asserted that the mainstream understanding of volatility is incorrect, Cole goes on to make a similar point about the role of diversification as the “foundation” of portfolio theory. In Cole’s opinion, diversification doesn’t magically reduce risk since risk can only be transmuted, not destroyed. He argues.

All modern portfolio theory does is transfer price risk into hidden short correlation risk…Many popular institutional investment strategies derive excess returns via implicit leveraged short correlation trades with hidden fragility.

Once again, Cole highlights risk parity funds, pointing out that the negative correlation between stocks and bonds has performed well during the last two decades (especially during the 2007-08 crisis). However, over the past 130 years, stocks and bonds have spent nearly three times as long moving in tandem than moving opposite one another. Both stocks and bonds could be vulnerable to rising interest rates and, in Cole’s opinion, rising interest rates might be the catalyst for the dark side of GSVB reflexivity to kick-in.

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.

While we can’t fault Cole’s superb explanation of how the GSVB might unwind, we might place greater emphasis on China as one of the potential catalysts. However, let’s not get picky. Following Cole’s logic, it’s patently clear that the reflexivity inherent in the GSVB means that the longer it unfolds and the bigger it becomes, the greater the odds of a sudden reversal or, as Cole terms it, a hyper-crash. The probability that the GSVB reflexivity is in central banks’ models is, of course, ZERO. The problem we face right now, as Cole states, is.

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).