February 7, 2018 / 10:44 AM / 12 days ago

Column: The biggest risk to the market? The market itself

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Jamie McGeever

LONDON (Reuters) - That crashing sound you hear as world stocks come tumbling down from their lofty peaks may have echoes of crises past, but the global market edifice today is in many ways unrecognisable from even Lehman and all that a decade ago.

There always have been, and always will be, financial market turbulence, but computer-driven algorithmic trading models and “passive” investing now drive flows, trading strategies and asset prices like never before.

The lack of human touch and speed of the latest plunge raise the questions: are market foundations more or less solid for that, and will the market fragility bred by record low volatility ultimately pose a system threat?

The common consensus is that the selling tsunami over the past few days, culminating in Wall Street’s biggest fall since 2011 on Monday, was a “volatility” event rather than an economic, policy or financial event.

This consensus also holds that market “fundamentals” remain solid. Global growth is its strongest and most broad-based since 2010, banks are better capitalized, corporate profits continue to grow and central banks are still net providers of liquidity.

Against that backdrop, it seemed like stocks could only go up while volatility would never go up. But in truth, all the recent “Goldilocks” and “melt up” chatter really did was fuel an already burning sense of complacency.

On Monday the VIX index of implied volatility on the S&P 500 registered its biggest one-day rise in its 28-year history, kicking in a flurry of vol-related hedging and options trading programmes that floored stock markets around the world.

$100 BILLION OUTFLOW

According to Michael O‘Sullivan, chief investment officer at Credit Suisse’s International Wealth Management division, short-volatility instruments gained nearly 300 percent last year. They have plunged by almost 80 percent in the past 24 hours.

A sudden spike in volatility wrong-footed all the positions and trading strategies that were predicated on low volatility.

When volatility is low, funds are encouraged to raise risk in order to make a certain level of return, and as vol falls further they may need to take on even more risk. After years doing this, the risk input into your model is dangerously high.

Marko Kolanovic and Bram Kaplan at JP Morgan estimate that the surge in volatility over the last 24 hours could lead to outflows from systematic trading strategies in the coming days of up to $100 billion.

Steen Jakobsen, chief investment officer at Saxo Bank, says the biggest risk to the market is the market itself, because everyone is pursuing the same strategies, be they “risk parity” funds, algo-driven programmes, exchange-traded funds (ETFs) or sellers of volatility.

For a while, it was a winning strategy.

The VIX fell to its lowest level ever last year below 9 percent, propelling risky assets to record highs as investors poured record amounts - some $441 billion, according to BAML - into equity exchange-traded funds.

ONE-WAY STREET

But on Monday the VIX posted its biggest ever one-day surge and on Tuesday it rose above 40 percent for only the fourth time since the global crash a decade ago.

In May 2010 the Greek crisis exploded and the S&P 500 lost 17 percent over two months. At the height of the euro zone crisis in August-October 2011 the S&P fell 20 percent. And when China devalued the yuan in August 2015 the S&P fell 12 percent over a 10-week period.

Wall Street has already lost 8 percent in just six days, half of those losses coming on Monday alone.

Jakobsen says there’s a simple rule of thumb that as long as the market isn’t down more than 5-6 percent over two-three days, “everything will be fine and volatility will tail off.” But a fall of more than 6-7 percent on consecutive closes means everyone has to start scrambling for cover and protection.

And that’s the danger. The algos, risk parity funds, ETFs, commodity trading advisors (CTAs) and volatility strategies are all positioned the same way. In many ways, the biggest risk to the market is the market itself.

“Plentiful liquidity has also allowed fast money, model and algorithmic investors to switch positions from long to short in quick time, adding to the downward shift in prices,” agreed Stephen Jones, chief investment officer at Kames Capital.

The extent of any contagion will become clearer in the days ahead. Crucially, foreign exchange, credit and fixed income markets so far appear pretty insulated.

The dollar is up but only a little, global high yields are up but only back to where they were in November, sovereign emerging market spreads are wider but only back to where they were a month ago, and peripheral euro zone debt spreads have barely budged.

While the dust settles, investors should retreat to the sidelines and leave the market to “hard-boiled traders”, according to Christian Gattiker, chief strategist and head research at Julius Baer.

“Market disruptions such as the current one are the stuff of traders, not investors, as origin and consequences are quite opaque,” Gattiker said.

Reporting by Jamie McGeever; Editing by Mark Heinrich

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