Reflections on Volatility by Mr. Practical

Fed Targets Volatility

Portfolio managers and almost all investors alike associate increased volatility with losses. If you chart “volatility” against the prices of all major asset classes, you find a significant negative correlation: high volatility is almost always accompanied by lower asset prices. The Federal Reserve knows this; that is why they have as a stated objective “low volatility”. High asset prices make the Fed’s job a lot easier, whatever that job really is (maybe it’s really to keep asset prices high; more on why that may be later).

Changes in Liquidity

So, what causes the level of volatility to change? The answer is simple, changes in liquidity. When money comes into asset markets, it drives prices up and dampens volatility: buyers carefully pick prices to pay which gives sellers the same luxury. When money comes out of the market, buying dries up and sellers are forced to sell at market prices causing volatility to pick up rapidly. Buyers don’t’ have to buy, but sellers usually have to sell.

Money Creation

So, what affects liquidity or the level and velocity of “money” moving in or out of markets.

First, “money” is created in two ways: the production process converting resources into income and credit expansion. When the economy picks up and GDP and profits are growing, money is being created in the sense that its value and its purchasing power is rising. We don’t see this of course because at the same time the Fed is increasing the supply of money, so we actually see more dollars/liquidity coming into the markets with those dollars having a greater affect. When the Fed increases the money supply it is really creating credit, so when the economy is expanding money is flowing into markets through income generation and credit expansion. Of course, the Fed can and has expanded credit when productivity is not increasing; in fact, credit expansion has been the primary source of market liquidity in recent decades. In 2008 we found ourselves with too much debt to by supported by the level of income generation and asset prices crashed as credit creation reversed and liquidity went to zero.

Sentiment

Which leads us to our second driver of liquidity, sentiment. Sentiment is really time preferences: the longer the time horizon, the more risk will an individual or institution assume. Money needed decades from now for retirement can take more risk than money needed in a few years for retirement. If markets were fully rational, time preferences would be determined solely by deductive logic. Unfortunately, human nature is just as much inductive as it is deductive. When stock prices are at all time highs, inductive logic drive investors into believing that high stock prices are telling us all is well and stocks are going higher.

Risk Taking

Sentiment is high and causing us to take more risk than we should. The more risk we take, the more money we take out of cash and put into risk, making prices go even higher.

Warning

One of the most important functions of the Fed (in their minds) is to keep sentiment high and the money flowing into risk. Apparently, they believe that high sentiment, even when it shouldn’t be, keeps expansions going longer. They may be right, but it also makes the eventual correction even worse. This process led us to 2008, and it will lead us to it again.

Mr. Practical

Mission Impossible​

As noted many times, sentiment is not a timing mechanism, but the warning is still appropriate.

The Fed is attempting to engineer a "soft landing" for the first time in history.

Given the numerous global imbalances and credit bubbles it's Mission Impossible.

Mike "Mish" Shedlock

"Mr. Practical" On Leverage, Options, and Derivative-Fueled Crashes

A Minyanville friend, "Mr. Practical", pinged me with his thoughts on leverage derivative-fueled market crashes.

Volatility Spikes, Equities Smashed: Congratulations Mr. 50-Cent VIX

A trader dubbed "Mr. 50-cent VIX" because he likes to buy masses of options priced near 50 cents, hit it big today.

Axel Merk on Volatility, Correlation: This Time is Different. Really?!

Axel Merk at Merk Investments discusses volatility and the next thing likely to blow sky high: Correlation strategies.

Mr. 50-Cent VIX Nets $200 Million

Mr. 50-Cent Vix made $400 million on his recent bet, but he was down $200 million for 2017.

Expect a Volatile Future: Short-Volatility Funds Flooded With Cash

Stock market volatility is a uni-directional measure. Volatility only rises when stocks decline. Curiously, the futures markets often work in reverse. When precious metals soar, the price of options on futures often rises instead of collapsing.

Housing Liquidity Crisis Coming: Debt Deflation Follows

A liquidity crisis in housing is on the way. Non-banks are at the center of the storm.

Confidence vs. Liquidity

Punk Ziegel analyst Richard Bove is saying some of the things that needs to be said. The article in question is: Fed rate cut won’t help markets. Here are a few select clips from the article.

Liquidity Crisis Coming: Here, There, Everywhere

Jim Puplava thinks a liquidity crisis is on the horizon. I agree, adding that the problem is global.

Just in the Nick of Time: Fidelity Bans Short Volatility Funds

Retail investors can no longer trade short volatility funds at Fidelity.