“But, as with markets, in the ocean the interesting things happen not at the equilibrium sea level which is seldom realized, they happen on the surface where ever-present disturbances cause further disturbances. That, after all, is where the boats are.” ― W. Brian Arthur

Financial markets exhibit a temporal phenomenon known as clustered volatility. That is, the existence of periods of low volatility followed by periods of high volatility. Low volatility reigns supreme when the the outcome of the cumulative actions of market participants mutually benefits the majority. And, by extension, reaffirms the confidence the majority of market participants have in their forecast, “investment process”, algorithm or “analytical framework” ― or, more crudely, heuristics that they use in making their trading or investment decisions. The majority continue to follow their “process” and among the minority that did not benefit in the run up all but the most stubborn gradually adapt their processes to implicitly or explicitly chase momentum. Low volatility begets low volatility.

High volatility often occurs when an external agent, such as President Trump tweeting about tariffs or the People’s Bank of China excessively tightening or loosening financial conditions, disrupts the seeming equilibrium in the market. All else being equal, which it never is, the impact of external agents on market volatility, however, tends to be fleeting. For example, the declining half-life of President Trump’s trade war related tweets impact on the US equity market.

A structural change in volatility generally occurs when some participants or a group of market participants alter their algorithm ― such as shifting from selling at the money puts to deep out of the money puts ― or investment process or by the entry of entirely new participants with a novel agenda ― like the Bank of Japan buying up ETFs as part of its QE programme ― to the market.

The changing of algorithms or processes may, of course, be in response to the actions of external agents or the impact said actions had on the market. Regardless, this “updating” allows the first movers to front-run or anticipate the behaviour of the majority, which in turn causes other investors to re-adapt. This adaptive behavior, if it successfully percolates and propagates, moves the market away from its seeming equilibrium and into a state of ‘chaos’. It is this process of re-adapting that tends to precipitate longer lasting bouts of higher volatility.

Robert F. Engle, the winner of the Nobel Prize in Economics in 2003, formally defined this process of random periods of low volatility alternating with high volatility in financial markets as the the generalised autoregressive conditional heteroskedasticity (GARCH) process. (Heteroskedasticity is where observations do not conform to a linear pattern. Instead, they tend to cluster.)

Momentum Massacre

From the Financial Times on 12 September 2019 (emphasis added):

“The stock market may appear tranquil again after a rollercoaster summer, but many analysts and investors are unnerved by violent moves beneath the surface, reviving memories of the 2007 “quant quake” that shook the computer-driven investment industry. The FTSE All-World equity index has rallied almost 3 per cent already this month, clawing back some of August’s losses. However, many highly popular stocks suffered a sudden and brutal sell-off this week, a reversal that analysts have already dubbed the “momentum crash”. The blow was particularly strong in the US, where strong-momentum stocks — those with the best recent record — tumbled 4 per cent on Monday, in the worst one-day performance since 2009, according to Wolfe Research. Only once before, in 1999, has such a rout afflicted momentum-fuelled smaller company stocks, according to investment bank JPMorgan.” This is massive,” said Yin Luo, head of quantitative strategy at Wolfe Research. “This is something that we haven’t seen for a long time. The question is why it’s happening, and what it means.” The flipside has been a dramatic renaissance for so-called “value” stocks — out-of-favour, often unglamorous companies in more economically sensitive industries. The S&P value index has climbed about 4 per cent this week and, compared with momentum stocks, enjoyed one of its biggest daily gains in a decade on Monday.

The chart below is the ratio of the S&P Growth index to the S&P Value index. We are struggling to find the “dramatic renaissance”.

Of course we are being more than a bit flippant. Nonetheless, we do not think it is time to completely drop momentum or growth stocks and load up on value stocks. Rather we think the market is in a transient phase where participants are updating their algorithms and processes to go beyond momentum.

Our prescription from June remains valid:

We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance regularly to avoid any lopsidedness in their portfolios.

The above has worked well in the recent “momentum massacre” and can continue to work well as long as uncertainty remains high and sentiment viciously waxes and wanes between optimism and pessimism. A slight adjustment to the above, however, is warranted as follows:

A barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals energy plays on the other.

Do Not Drop Momentum ― Not Completely Anyway

Dropping momentum or growth completely would be akin to calling the end of the transition away from actively managed portfolios to passively managed allocations that has accelerated since the Global Financial Crisis. Passive allocations are implicitly momentum seeking strategies. A strong secular trend is not upended by a 4 per cent move, it will take a crisis or a severe re-think of strategic asset allocation by the managers of the largest pools of capital to bring about an end to the trend.

The rise of passive investing, along with systematic volatility selling strategies, has contributed to the dampening of volatility since the Global Financial Crisis. A growing share of passive allocations, however, is somewhat like increasing leverage. As passive flows now make up the lion’s share of capital market flows, the actions of active investors are spread over a smaller segment of the investment universe. As the size of the active universe shrinks, in terms of what could be described as, in the case of stocks, free float market capitalisation minus passive allocations, the actions of active investors begin to have an exaggerated impact and give rise to higher volatility.

Simply put, the passive flows versus volatility curve is convex. Initially, increasing passive flows dampen volatility but beyond some hitherto unknown level increasing passive flows lead to higher volatility.

Why Energy Over Precious Metals?

Without delving into the geopolitics of it, the attacks on the Saudi Arabian oilfield should remind major oil consumers ― airlines, refiners, transportation companies and emerging economies such as India and China ― to review their energy security and hedging strategies. To balance future energy needs and to not become hostage to a rising geopolitical risk premium in the price of oil. This should lead to a rise in demand for oil at the margin; commodity prices are, of course, set at the margin.

The other angle is that if anything is going to take down the almighty bond bull market its going to be either: (1) fiscal spending by the G-7 governments of the like that we have never seen; or (2) a sharp and sustained increase in oil prices.

Lastly on energy, if Iran is, rightly or wrongly, shown to be the perpetrator of the attacks, China may have to reconsider it decision to purchase Iranian oil.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.