Why Market Volatility Is in Secular Decline and How to Adjust to It

VIX and other “fear index” measures of market volatility are in secular decline. Markets are driven less by human emotion and more by automated trading programs and data dependent monetary policy than they used to be. These forces are proven volatility crushers.

Automated trading programs (AT, HFT, robots, etc.) dominate trading volumes in nearly all public, liquidly traded financial markets. Morgan Stanley estimated up to 84% of all orders placed on US stock exchanges originate from automated trading programs. Aite Group LLC, a Boston-based consulting group that analyzed Bank of International Settlements (BIS) data on spot foreign exchange dealing, estimates 81% of FX trading will be automated by next year.

By design, automated trading is designed to remove the weakest link in trading performance: human emotion. That means these programs are less likely to produce an outsized emotional reaction to incoming market data and are more likely to engage in the type of “range crunching” strategies that strangle volatility.

Humans are prone to overestimating the importance of each data point, whereas robots merely attempt to assign a statistically significant weighting. Let’s face it–most of the data points hitting markets each day are just noise. Only a few items really matter. One Global Dairy Trade auction probably shouldn’t move the New Zealand dollar by 2% in a rational market, though any trader loves to see irrational volatility they can seize upon. Automated trading programs are typically designed to fade overreactions rather than pile into them.

Additionally, monetary policy in the post Great Financial Crisis (GFC) era increasingly aims to lower market volatility. It does this by reacting to sizable asset price moves with counter actions–when equities fall sharply on fear, in comes your friendly neighborhood central banker hinting at fresh stimulus to stop the bleeding via monetary policy loosening channels. When risk markets are melting up, it is just a matter of time before a slightly less dovish central banker attempts to sprinkle in a shred of reality with hints of higher interest rates down the road.

Even during a potential future crisis, VIX will probably be muted somewhat compared to where it would have been in a similar magnitude of crisis had it occurred years ago. This is not a cyclical phenomenon; it is secular and structural. You need to accept this as a trader and adjust to it rather than thinking you identified a temporary anomaly of markets underpricing risk as most financial publications have erroneously suggested.

How should traders adjust to the “new world order” of low vol? First, stop chasing momentum. Trend following momentum strategies are not worth risking one’s capital unless the VIX (or comparable vol index) is above 20. Second, lengthen your holding time frame. Trying to rapid fire market orders in a “watching paint dry” market is a good way to chop yourself right into the margin call poor house. Finally, and most importantly, financial assets can trade at seemingly grossly overpriced valuation levels longer than you can stay solvent shorting “expensive markets.” That is because the volatility risk premium is diminished when VIX is crawling on the floor around a 10 handle. Lower volatility means higher asset prices, all else equal.

Bottom Line: Traders and investors should expect volatility to remain below historic norms. Central banks are long past a day where they will or even can allow true price discovery by fully letting the air out of the asset bubbles they created. That, along with increased trading automation and counter cyclical  monetary policy could allow elevated asset prices with low volatility to persist for much longer than many analysts estimate.

French Elections This Weekend Unlikely to Produce Destabilizing Outcome

  • Out-sized market attention has been placed on the French general election this weekend on Sunday, April 23. This is due to the significant geopolitical risk posed by one of the more extreme candidates destabilizing Europe should they somehow pull off an upset victory.
  • This risk is far overblown. Populist right victories in 2016 by the UK Brexit campaign and Donald Trump created a misplaced fear bias for something similar happening in France or elsewhere in Europe. Trust in political polling is understandably low.
  • While the first round election on April 23 is somewhat of a close call, the second round runoff on May 7 will not be. The margin of error for Emmanual Macron (Independent) beating Marine Le Pen (Front National) or Jean-Luc Mélenchon (Unbowed France) in the second round is more than 20 points. That is far beyond the margin of error at this time before both the UK referendum and US presidential election. Not even close.
  • The main risk to keep an eye on at this point is both Le Pen and Mélenchon beating out the field in the first round of elections this weekend, meaning one of them would be the ultimate victor after round 2 since the threat of one of the more mainstream candidates would be removed. Stranger things have happened, but the probability of this is perhaps about 10%.
  • If the first round results indicate almost any outcome other than that posed by the point above, the euro should rally, French bonds should recover, and a global equity relief rally should ensue early next week, all else equal. It is difficult to support the opposing view with 10% odds at best per my analysis.

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Sky Is the Limit for Gold but Correction Risk Grows

  • Gold raged $50 per troy oz. higher after the last note posted on this site 27 March. Sitting on gold longs was my preferable strategy during the past few weeks as most other asset classes had difficulties finding their footing in either direction.
  • The long distance gold marathon higher is far from over, but it is time for traders to lock in some gains on partial positions and/or raise stops per prudent risk management.
  • Chatter builds surrounding Republican plans to revive healthcare, tax, infrastructure, and regulatory reform efforts. While there is a serious lack of budgetary space to enact the more ambitious elements of the Trump growth agenda, negative sentiment towards said reforms may have peaked for now.
  • Geopolitical risks in France of a Le Pen victory are far overblown.
  • The Korean peninsula is still a wild card but constructive developments in recent US-China relations will be sufficient to keep North Korea out of the top headline spot now that the 105 year Kim-Il anniversary has passed. The Trump Administration decision to not label China a currency manipulator is not unrelated.

Bottom line: long term gold investors should stay long and strong in their positions while shorter term traders should be more cautious by protecting recent gains in case there is a bull market correction.

gold 042017