"People Ask, Where"s The Leverage This Time?" - Eric Peters Answers

One of the Fed"s recurring arguments meant to explain why the financial system is more stable now than it was 10 years ago, and is therefore less prone to a Lehman or "Black monday"-type event, (which in turn is meant to justify the Fed"s blowing of a 31x Shiller PE bubble) is that there is generally less leverage in the system, and as a result a sudden, explosive leverage unwind is far less likely... or at least that"s what the Fed"s recently departed vice Chair, and top macroprudential regulator, Stanley Fischer has claimed.

But is Fischer right? Is systemic leverage truly lower? The answer is "of course not" as anyone who has observed the trends not only among vol trading products, where vega has never been higher, but also among corporate leverage, sovereign debt, and the record duration exposure can confirm. It"s just not where the Fed usually would look...

Which is why in the excerpt below, taken from the latest One River asset management weekend notes, CIO Eric Peters explains to US central bankers - and everyone else - not only why the Fed is yet again so precariously wrong, but also where all the record leverage is to be found this time around.

This Time, by Eric Peters

“People ask, ‘Where’s the leverage this time?’” said the investor. Last cycle it was housing, banks.

 

“People ask, ‘Where will we get a loss in value severe enough to sustain an asset price decline?’” he continued. Banks deleveraged, the economy is reasonably healthy.

 

“People say, ‘What’s good for the economy is good for the stock market,’” he said.

 

“People say, ‘I can see that there may be real market liquidity problems, but that’s a short-lived price shock, not a value shock,’” he explained.

 

“You see, people generally look for things they’ve seen before.”

 

“There’s less concentrated leverage in the economy than in 2008, but more leverage spread broadly across the economy this time,” said the same investor.

 

“The leverage is in risk parity strategies. There is greater duration and structural leverage.”

 

As volatility declines and Sharpe ratios rise, investors can expand leverage without the appearance of increasing risk.

 

“People move from senior-secured debt to unsecured. They buy 10yr Italian telecom debt instead of 5yr. This time, the rise in system-wide risk is not explicit leverage, it is implicit leverage.”

 

“Companies are leveraging themselves this cycle,” explained the same investor, marveling at the scale of bond issuance to fund stock buybacks.

 

“When people buy the stock of a company that is highly geared, they have more risk.” It is inescapable.

 

“It is not so much that a few sectors are insanely overvalued or explicitly overleveraged this time, it is that everything is overvalued and implicitly overleveraged,” he said.

 

“And what people struggle to see is that this time it will be a financial accident with economic consequences, not the other way around.”

The Cost Of Market Crash Insurance Just Hit A Record High

With the VIX surging, and then quickly getting pummeled on two occasions in the past three weeks, dizzy traders could be forgiven to assume that any latent "risk off" threat, whether from North Korea or the US political front, has been taken off the table. However, a deeper look inside the vol surface reveals something very different: with increasingly more analysts and traders warning that volatility is set for a sharp return this fall, equities have already been adjusting to the increased probability of a "tail event." However, instead of buying VIX futures, call or ETPs, they have been doing so by bidding up the price of OTM equity put options, or equivalently, by steepening the S&P 500 put skew and.

As a reminder, a put skew shows how much more expensive it is to buy deep OTM puts vs puts that are in the money or in other words, a levered bet on (or hedge against) a market crash.

 And as the following chart from Bank of America shows, the S&P put skew is now at the highest level on record, making the relative price of tail hedges the highest in 13 years as traders are quietly bracing for a sharp market crash.

While not new, Bank of America again underscored the potential risk in the coming months to actively managed portfolios from a possible volatility flaring event, primarily impacting risk-parity portfolios. This is what the team of BofA Benjamin Bowler wrote in an overnight note:

Both equity and bond valuations are high. In a report from last week, our equity strategists pointed out that the S&P 500 forward P/E expanded in July and hit its loftiest level since the Tech Bubble. Even at these elevated levels, equities look attractive relative to bonds whose risk premium is more than 50% above its long-term average. This is clearly a concern for portfolios that invest in both classes (risk parity). A significant risk for multi-asset managers going forward is a breakdown in the diversification between stocks and bonds in which we see simultaneous declines in both asset classes similar to the ‘Taper Tantrum’ in May/Jun-13 or to a slightly lesser extent the risk-off event from Aug-15 two years ago. It may be surprising to an equity investor, but for a multi-asset manager these two declines were the largest since 2008 and equal to 50% of the drawdowns from the GFC. With multi-asset vol so low, for those managers who use leverage, the leverage levels may be high and therefore their portfolios may be more sensitive to a breakdown in correlation.

Bank of America then writes that with both rates and equity volatility at historically low levels, however with correlations between the two rising, going into the fall - even if equities and rates remain range-bound - an uptick in volatility could lead to outsized jumps in a cross-asset vol pair trade.

Interestingly, for most of this year an increase in equity volatility has tended to coincide with an increase of rates volatility. The payout is dependent on rates going higher and equities falling from current levels, so it is implicitly short equity/rates correlation. This correlation has had an increase over the past month and provides for an attractive entry point (Chart 11)."

Indeed, while many traders point out that intra-equity correlation has dropped to near all time lows, traditionally a welcome sign for active investors as it provides return dispersion and alpha creation abilities that are detached from broader macro conditions, looking at cross-asset vol shows a very different picture. As the following two charts show, correlation between rates and equity volatility, or MOVE and VIX, shows a sharp spike in recent weeks. In fact, as Chart 10 shows, the correlation is now the third highest on record. Confirming this troubling observation, Chart 11 shows that the correlation between the underlying asset classes has also soared in recent weeks, after plumbing near record lows just weeks ago.

To explain the surge in put skew, below we present several observations from BofA on why the recent period of record low volatility appears to be coming to an abrupt end.

1. The S&P recorded three moves of at least +/- 1% within a six days span, the first time this has occurred since September 2016. In fact, prior to the 1.48% loss on 10-Aug, SPX hasn’t moved morethan +/- 0.3% in a single day since 19-Jul.

"These larger one-day moves are evidence that the record-low vol we’ve seen throughout the summer may be starting to come to an end. As we’ve noted recently, seasonal trends and a fall which encompasses numerous catalysts (including the debt ceiling deadline, the September FOMC meeting, and political reform negotiations) suggest that the extreme quiet may not last much longer."

2. Last week, the VIX recorded +30% spikes twice in a six day period (10-Aug, when the VIX jumped 44.37% and 17-Aug, when the VIX jumped 32.45%). This is only the third time ever that we’ve seen two such drastic moves occur in that short a period of time.

"Notably, the only other two times this has occurred were early August 2011, immediately following S&P’s downgrade of US government debt, and August 2015, when markets were rattled over fear of slowing growth in China. The seasonally low vol environment typically seen during late summer may be a contributing factor to these occurrences as each has happened during August."

3. On 8-Aug-17, the total number of VIX call options (including all strikes and all expiration dates) was 1,994,418, an all-time high, as investors piled into long call options amid the rising tensions with North Korea. The amount of options traded surpassed other notable highs on 3-Feb-2014 and 13-July-2015, when 1.85mn and 1.93mn call options were traded, respectively. "The former period saw investors buying VIX calls due to a global selloff sparked by concerns over Asia and EM, and the latter period saw purchases on the back of Grexit fears."

4. On 17-Aug SPX fell 1.5%, the second largest decline YTD since the 17-May 1.8% drop and similar to the 1.4% sell-off on 10- Aug. However, in one regard this sell-off was remarkably different.

"Specifically, markets this time around appeared to have made little distinction between different pockets of the market. For instance, the underperformance of cyclical sectors vs. defensives was less pronounced in the latest sell-off. Consequently, also the relative moves in volatility were not as significant as in the past two largest sell-offs YTD. This could signal the beginning of a new narrative whereby market participants are more skeptical about the prospective of a pro-business agenda being pushed forward in Washington; as such they stop differentiating between potential losers and winners from the aforementioned agenda."

What Happens When $500 Billion in Risk Parity Funds Hit "Sell" on Stocks?

The market riggers are now pulling the pin.

All market rigs end badly. And given the fact that this one has been particularly egregious, the results will be quite ugly.

You cannot pin the S&P 500, perhaps the single most important stock index in the world, for weeks and expect it to end well. This is particularly true when you’re pinning it using Risk Parity Funds and their “buy/sell” algorithms.

Those same algorithms that have mindlessly bought stocks every time the VIX gets smashed, will mindlessly SELL stocks when the VIX explodes higher.

And the VIX will be exploding higher. Historically, the average level for the VIX since 1993 has been around 18-20. We’ve been stock at 9-10 for weeks now.

Not anymore. Today’s move could very well be the start of something big. The below chart predicts a move to 30 if not 40 in the coming weeks. If this was a chart for an individual stock, you’d say it was a screaming buy.

So what happens when the VIX spikes to 30-40 and the $500 billion worth of capital managed by Risk Parity Funds starts dumping stocks?

Buckle up, we’re about to fund out.

On that note, we are already preparing our clients for this with a 21-page investment report titled the Stock Market Crash Survival Guide.

In it, we outline the coming collapse will unfold…which investments will perform best… and how to take out “crash” insurance trades that will pay out huge returns during a market collapse.

We’ve extended our offer to download this report FREE due to today’s market breakdown. But this is the last day this report will be available to the general public.

To pick up one of the last remaining copies…

https://www.phoenixcapitalmarketing.com/stockmarketcrash.html

Best Regards

Graham Summers

Chief Market Strategist

Phoenix Capital Research

 

 

 

Goldman: "Periods Of Low Vol End In Tears... The Biggest Risk Is Central Banks"

One month ago, unleashing the latest series of warnings that the current period of low volatility will not have a very unhappy ending, came from Bank of America, which said that "These Markets Are Very Weird." A few weeks later, JPM" Marko Kolanovic warned that complacency will end in "catastrophic losses" for short vol strategies followed promptly by Deutsche Bank"s Aleksandar Kocic who demonstrated that there is no scarcity of scary adjectives when he likewise warned that the current period of market "metastability" will showed lead to "cataclysmic events." Now it"s Goldman"s turn.

In a note by Goldman"s Christian Glissman seeking to explain "The upside of boring - risks and asset allocation in low volatility regimes", the vol strategist joins the bandwagon and writes that while "low volatility periods do not have to end in tears, they often do." His explanation:

Volatility tends to cluster and is often low for a good reason – this indicates investors should add risk during those periods. However, a prolonged low vol period can also eventually result in excessive risk  taking and latent risks from elevated valuations. But moving out of a low vol period does not have to come with a material ‘risk off’, at least initially. Usually volatility tends to spike and equities settle into a higher volatility regime first (Exhibit 37) and the average drawdown is less than 5%.

Markets often enter a higher vol regime before there are larger equity corrections, usually 6-24 months later (Exhibit 38). This suggests a more gradual risk reduction as markets shift into a more persistent higher volatility regime as the macro backdrop worsens. Currently, we see little recession risk in the next 12 months although growth momentum may have peaked and the US economy is moving more late cycle.

So if not a recession, what could unleash more images of traders with hands on their faces? Here Goldman channels the latest note by Matt King, and says that the "bigger risk could prove to be central bank tightening, which could drive more volatility in the near term, especially owing to the elevated uncertainty around the balance sheet runoff by the Fed and ECB."

Further, volatility can spike due to unexpected shocks and tail events – with higher vol of vol risk, running increased cash allocations and some tail risk protection appears sensible. This is particularly true as valuations across risky assets remain high, resulting in poor asymmetry for LT returns.

The shift from a low volatility regime to a higher is shown below:

There are other dangers too, for example low volatility masking correlation risk in multi-asset portfolios.

In multi-asset portfolios, investors might face further risk based on the premise of diversification. Absolute cross-asset correlations tend to increase with higher volatility (Exhibit 39). This is especially a risk for risk parity funds and volatility target funds which often increase risk based on volatility by asset class and on a portfolio level. Since the 1990s bonds have provided hedges for equities in periods of higher volatility, allowing multi-asset investors to run higher risk/leverage levels. But right now, as both bonds and equities appear expensive, bonds may be less good hedges for equities in drawdowns, and there is the potential for negative rate shocks to weigh on equities, as central banks tighten policy. Commodities have helped in high inflation periods like the 1970s but they have been more a source of risk recently, with large oil price declines and still-low inflation.

So why not just go long vol? Well, in a world of BTFD the theta is simply far too great. The result: everyone is shorting vol instead, even though "Short vol strategies are becoming riskier." For more on this, see the latest Kolanovic note.

Unsurprisingly, short vol strategies tend to very profitable in low vol periods, while being long vol tends to be costly. Exhibit 41 shows that being long vol through the VXX (long shorter-dated VIX future ETF) has been very costly since 2011 – the VXX is down 99% since then. It is not just low realised S&P 500 vol but also the contango in the VIX futures curve (in-line steep equity vol curves) that creates a painful rolldown, even if volatility is unchanged (see Navigating the VIX ETP market, April 25, 2017). VIX options can be a better way to position for a rise in the VIX.

As the VIX spikes revert rapidly, it has also been particularly difficult to capture ‘risk off’ episodes through a long VIX future position recently. On the flipside, this has made short vol a popular (and profitable) carry trade; for example, the XIV (short shorter-dated VIX future ETF) has nearly tripled since the beginning of last year. As a result, the net and outright short position in VIX futures is at all-time highs. But the risk of short vol strategies in most markets is clearly rising. For example on May 17, 2017, following to the VIX spike due to concerns on the impeachment of President Trump, the XIV was down 18%.

Taking all of the above, Goldman"s advice: go to cash, and reduce risk.

This further strengthens the case for increased cash allocations and also for broader diversification. Alternatives such as real estate and private equity can help, although they often introduce liquidity risk in the portfolio and also carry equity and duration risk. Generally, a more momentum-based investment approach can help manage risk-adjusted returns in periods of rising volatility – with declining momentum in risky assets in low vol periods, we believe investors should further reduce risk.

One last chart: according to Goldman calculations, 1-month S&P500 realized vol now finds itself in the 0%th percentile. It has never been lower.

Is Risk Parity Driving The Market?

Authored by Brean Capital"s Peter Tchir via Forbes.com,

I am have more and more discussions about Risk Parity.

While Bridgewater is the best known and largest advocate of Risk Parity - it can be implemented in a simple form by virtually anyone.

Sophisticated Risk Parity strategies involve balancing multiple asset classes (global bonds, global equities, commodities, FX, etc.) in the "correct" proportions to achieve a desired level of portfolio risk while still have positive expected returns.

At its most basic level - it is buying stocks AND buying bonds under the assumption (hope) that when one goes down, the other goes up, dampening volatility while generating positive returns over time.

There is an appeal to buying bonds as a "hedge" against equity risk rather than buying options or buying VIX based ETFs and ETNs.  In an "ideal" world, buying treasuries as a hedge generates income while offering some "risk-off" protection; whereas, buying options tends to just drain money time and again.

One big question is "why are treasuries doing so well and stocks not reacting?"

There are a lot of potential answers, but one thing that would explain some of the more perplexing market moves would be that more investors are allocating money, directly or indirectly into Risk Parity strategies.

• Investors wouldn"t need to sell stocks out of fear as they would be hedged - check


• Investors wouldn"t be buying options so the price of volatility, or VIX, would be low - check


• Investors would be buying bonds, particularly "safe" bonds - check

Three things that are happening in the market, that are not easy to reconcile, can be explained by a growing interest in Risk Parity.

Because this strategy can be implemented in so many ways, it is difficult to detect whether I am right or not, but there are some indications that this might be occurring

• IEF, TLT and LQD (treasury and investment grade bond ETFs) have all had inflows


• Risk Parity and "Adaptive Risk Allocation" Funds, like CRAZX (one of my favorite tickers) have had inflows

If I am correct, the risk in the  market is not to increasing volatility but something that changes the relationship to stocks and bonds that causes them to both drop.

The strategy has had long periods of success - not surprisingly up until the Financial crisis as bond yields were high and reasonably stable while equities rallied.

In the Quantitative Easing Period when Central Banks helped inflate the price of all assets - which was rudely interrupted by the Taper Tantrum and again in the post Brexit era of more central bank support.

It is far from clear how well this strategy will do going forward, especially if central banks are scaling back their support and it is becoming a crowded trade in a world where liquidity often seems fickle.

"Something For Nothing" All-Weather Funds Disappoint In Post-Election Era

Variously marketed as "all-weather", "all-season", or "bulletproof", the so-called "risk-parity" strategies of some of the world"s largest hedge funds have been anything but "stable" since the election as the combination of leverage and bond losses have crushed the gains from an exuberant equity market.

Promise people something for nothing and you are going to attract a lot of attention. Stumble in the process and the critics will be quick to pounce.

As The Wall Street Journal reports, the weeks since the election have been rough for one of the most polarizing investment strategies out there: risk parity.

The strategy - which simply put, involves using diversification - and sometimes borrowed money (leverage) - to find an (historically-optimized) balance between risk and return.

Bridgewater’s variant of this strategy, for example, has historically used borrowed money to invest about $1.50 for each dollar in assets, often putting the leverage in historically less-volatile bonds. The goal is stocklike returns with less volatility.

Problems occur when histroical relationships between asset-classes break down... just as they did during this year (when the historical norm of inversely correlated bond and stock prices reversed completely)...

The post-election rally in stocks and selloff in bonds hit these portfolios, embolding critics of the approach...

Bonds have been in a bull market for 35 years, so adding leverage would have produced strong returns for a modest increase in volatility, says Ben Inker of fund management firm GMO. He also argues that “volatility and risk are not the same.”

As WSJ concludes, the strategy has sharply underperformed both stocks and a traditional 60% stock 40% bond index fund offered by Vanguard since 1993.

Without the benefit of leverage, lower volatility equals lower returns. Even with it, though, there are occasional bumps in the road. For investors whose moods are as fickle as the weather, risk parity may involve more risk than reward.