If you can keep your head when all about you are losing theirs…….
Not only is IF by Rudyard Kipling a great set of words to have in the back of your head but it can also prove worthy in financial markets. Volatility is what causes men and women around the world to lose their minds, it is the manifestation of fear being played out in front of you like a particularly gruesome Quentin Tarantino scene.
People like to think they can control their environment, most people are process driven and tend to fall into routine very easily and with that brings comfort. Calmness is comfort.
When volatility strikes there is a disruption to this environment and things tend to morph from black and white to 50 shades of gray (sorry couldn’t resist). It is within this environment that fortunes are made and lost in financial markets.
When markets go through a period of intense volatility, like we have recently in the equity world particularly, it essentially creates an environment of risk transfer. It is the punishment for group-think. Risk gets transferred from the weak to strong, or from the sheep to the wolves.
Most good investors (wolves) will relish periods of high volatility as it creates an environment of rich pickings to enter investments on better terms than they could the day before. If they pick their opportunities correctly they know that the current environment will not last long, i.e. investors move from calm to fear and back again in relatively regular cycles.
Most bad investors or willing participants in Group-think (sheep) will hate periods of high volatility as it creates a stressful environment that they are not in control of anymore, or rather it is in control of them. They will actively engage in this volatility and actually in an ironic twist serve to increase it by shedding risk or cutting positions. The shedding of this risk is designed to put them back into their comfort zone, and will only stop when they have achieved this. In the meantime they have just transferred all their risk to the wolf , on the wolf’s terms not theirs.
I like volatility as it creates this process of risk transfer and changes the status quo. Group-think is often manifested in markets as an accumulation of investors in similar positions/ assets. the benefit of this is often great comfort to the investor, ” I must be right, if everyone else thinks so” and so over time this permeates more and more. Volatility punishes this attitude with relatively swift precision.
For the last few years equity markets have grinded higher and higher, all the while I have barely heard a positive word spoken about the rally, Investors moaning about the action of the FED causing a bubble in this, that and the other. Investors bemoaning the ZIRP of the FED, that it causes distortions and not leaving any room for further monetary policy actions. However despite all this moaning and push back, investors have generally been long equities or mainly assets that are prone to move higher in price with inflation, and as the saying goes ” don’t fight the FED”
This group-think has just been punished. the FED stopped QE nearly a year ago, and is on course for a rate rise sometime in the next few months, the global economy is experiencing much lower inflation than desired (mainly due to oil prices) so one by one assets that have been the pro inflation trade are crumbling, first gold. then oil, property prices seem to be stalling in some major economies or at least not rising with the same wreckless abandon for the last few years.
Those in concentrated risk positions just got punished, those who embraced the volatility and picked their opportunities will benefit in the medium to long term.
Below is a chart of the VVIX index, this is a measure of the VOLATILITY OF VOLATILITY , i.e. not only do we measure the volatility of asset prices, but we measure how volatile this volatility is!!! I think its a great indicator of where investors head are at.
As you will see from the rough line I drew horizontally across the chart we are currently in fairly unchartered territory. What this means is that the previous two weeks has seen the most amount of volatility (and remember that brings risk transfer) that we have seen since this index was created, and considering what has gone on over the last eight years that is saying something.
However despite this extreme volatility, see how, when we do experience these spikes, they always settle back down to a more normal or average level, you could call this mean-reversion if you want. I like to think of it as risk transfer, or Darwinian-esque. The strong hands came in a settled the market from the weak hands, those who embraced volatility versus those who ran from it played out.
To sum up, it is not volatility that scares good investors, its the opposite – calmness. Calmness indicates you are with the herd, and while that can be comforting at times, it ultimately leads to some very scary moments and dealings with wolves.