Evil we cannot see or touch surrounds and subsumes us: Spooky pre-Halloween market analysis

Tuesday, Oct 23 2018 by

Its been a bit choppy at times in 2018...and today is one of those days. Is there more to it?

Here's a take on market structure and risk issues from Chris Cole of Artemis Capital Management, a volatility trading firm...


It's a lengthy read but great information. Recommended if you want to frighten yourself :)

Cole is basically saying that the market is caught in a self-feeding self-referential loop of Price = Liquidity = Value = Price = ....sort of post-modern performance art!

FWIW Where I believe Cole could be wrong is in an implicit assumption of the structure of the world and markets staying the same as they have in recent memory (say since turn of century). What do I mean? The pre-eminent status of US and dollar in a world dominated by Western financialised economics. I'm not a conspiracy theory wingnut...honest...but I believe we are living through the (at least temporary) demise of US dominance. Note, in the past it was normal to have periods where the US dollar could be weak and financial markets too. It is not a immutable rule that market stress is concomitant with strong USD.

Most importantly for markets that means the decline in the status of US dollar. Its a decade long event not overnight. Uncertain multi-polarity takes it place rather than say a swift shift to Renminbi. But a more immediate consequence of this uncertainty/shift would be the need for US to monetise to support its own need for debt issuance to support spending (in the choice between 'austerity' and central bank monetary operations the latter will win every time in the US). This provides liquidity to keep the market processes afloat rather than implode in volatility-liquidity cataclysm. Looking at the performance of real assets in countries like Venezuela as they undergo inflationary hyper monetisation is a clue. The US will not be the same and a failed state but the pattern re a rush to real assets for protection could happen. Then Cole's analysis is wrong in a big picture sense (though right re mechanics short run) as the run away momentum and valuation in US stocks turns out to be that unknowing and rather unfathomable wisdom of the crowd.

My view might be wrong...but unless you can conceive of a different reason why…

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Nick Ray 24th Oct '18 1 of 1

It was an interesting read but I didn't agree with a lot of it.

Firstly the terminology is used very loosely. It tends to use "volatility" to mean "very high volatility" as in for example:

Volatility is always the failure of medium

Secondly, it seems to treat passive versus active investing as meaning the same thing as value versus momentum investing, whereas for me they are completely different things. His "simulation" - which he claimed showed how passive investing affected volatility and excess returns - seems to me to be a simulation of value versus momentum instead. (And "excess return" does not mean the same as "alpha" either.)

You cannot really talk about passive/active without discussing the concept of market efficiency and the CAPM. Formally solving for these gives you the concept of a regression with two parameters alpha and beta (the security market line). Then a passive approach assumes that the market is efficient enough that your best option is to track the whole market (and alpha=0), and the active approach attempts to beat the market by finding a positive alpha.

If everyone became a passive investor the market would cease to be efficient and hence an active approach would work better. As a result the market should be in a dynamic equilibrium where active and passive balance. (But not in the way shown in the graph.)

Since the original Modern Portfolio Theory was created, it has been realised that there can be many "betas" in the regression. These betas are often called "factors" and give rise to factor investing. The correct identification of factors I would argue does not destabilise the market or increase volatility but instead nudges it towards greater efficiency.

Once the paper starts talking about the dangers of derivatives when liquidity dries up and the dangers of trading the VIX/XIV I would say he is on stronger ground.

There is one statement I do strongly agree with though: he implies it is not true that "Volatility accurately measures risk". I quite agree. Volatility measures the standard deviation of stock (or index) returns. That's all it does. (And very useful it is in that role.)

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