INVESTMENT ADVISER | ISSUE 09 2024 33
When we invest money on behalf of our clients , we seek superior businesses with durable competitive advantages and commensurate high returns on capital . The aim is that the compounding nature of these businesses builds wealth over the medium and long term .
But not every market participant shares the same goal . Much of the volume in the market is driven by shorter-term traders , many of whom are exploiting strategies they believe can generate return while diminishing risk . Occasionally these strategies can add significant volatility to returns .
We have just gone through a period where such strategies have been disappointed . The recent spike in volatility in the chart of VIX ( the Chicago Board Options Exchange ' s CBOE Volatility Index ) can be seen as a sign of these strategies being frustrated and closed out on a massive scale ( Figure 1 ).
FIGURE 1 : A SPIKING VIX
Source : Bloomberg , as at 16 August 2024
I am far from an expert in such strategies , but a nonexhaustive list would include : trend-following calls to action ; risk parity asset allocators ; equity baskets ; the Yen carry trade ( funding in a low-cost currency that was a “ one-way ” bet lower ); and theme ETFs ( AI beneficiaries , obesity , Japan value etc ). They had all been making money until the market rotation unsettled them and sent them heading for the exit . Japan falling 12 % in a day 1 suggests technical-dominated trading . It reminded me of the 1987 crash ( I was very young !). Back then , before the October investors had also made a lot of money . The Federal Reserve had already raised rates three times , the last being a 50bps rise to 7.25 % in the September . 2 But suddenly in mid-October everyone headed for the exit at the same time . The culprit then was portfolio insurance , a strategy that promised equity-like returns with significantly lower downside risks ; the trigger was an above-expected trade deficit number ; the result was the creation of forced sellers and a market event . The spike in volatility as the S & P fell 23 % in a single day was such that initially those owning calls made money on the drop as the spike in volatility overwhelmed the price drop in a Black-Scholes 3 valuation world ( this may be an urban myth ).
Coming back to today , we have just seen a spike in volatility not far short of that seen during the collapse of the financial system during the Global Financial Crisis ( GFC ) and with the onset of the Covid-19 pandemic . What caused it this time ? Apparently , initial jobless claims in the US were a bit higher than expected and suddenly we were heading for recession ( subsequent examination of the data showed an increase in the labour force participation rate was to blame ).
We live in a capitalist world and as such price is meant to be a signal . So , what has recent price action told us :
• Economic growth is slowing . The odds of recession have gone up , but are still slim .
• We are leaving the post-pandemic period of high inflation … at least for now ? ( Figure 2 )