September and October have been among the quietest months ever recorded in financial market history.
Stocks in the US keep posting all-time highs — a signal of confidence — and even in Europe we are clawing higher month by month.
It can be confusing why stories like Trump, North Korea, Spain, the Middle East, and Brexit are not important to market participants.
There is confidence that nothing will go wrong and to confirm that, hedge funds, who would normally buy insurance against market fluctuations, are selling risk insurance to gain the premiums.
This global short volatility trade is upwards of $2tn+ in outstanding exposure. The trade is defined as a financial strategy that relies on the assumption of market stability to generate returns.
If that trade goes wrong i.e. volatility spikes, losses have to be offset by attempting to gain profits selling the stock markets. That would mean extreme selling pressure all at once — in other words, a stock market, severe correction, or even a crash.
A volatility spike happened on October 19, 1987: markets crashed at record speed, including a -20% loss in the S&P 500 Index, and a spike to 150% in volatility. Black Monday occurred during a booming stock market, economic expansion, and rising interest rates.
This casual attitude to the markets always rising is behaviour we see in a bubble. The crash in 1987 was caused by computer-generated trading — this multi-trillion-dollar short volatility trade could cause a similar outcome today. As investors and traders continue to make money, it is easy to shut out risk and reality.
‘This time is different’ is a denial state of mind and very prevalent. But, this time, it is different. Yes, the market is locked and loaded and anything could cause a stampede. However, we are in an incredibly stable economic global environment.
Everything is just chugging along and nothing looks overheated. US and European growth is good, but not racing. Inflation is low and central banks are still accommodative — Mario Draghi has just confirmed he will print money up until September, 2018. That means no rate rise in the eurozone until 2019, at the earliest.
The market is very relaxed about Trump, Brexit, Korea, Spain, because none of those stories are likely to tip the global economies into a recession. In effect, any stock market correction in the near future should be an opportunity to buy, not to sell.
Interest rates are very low and for many money managers there is little opportunity to make their clients’ money, other than riding the stock market.
The ‘2 and 20’ rule (charging 2% commission and participating in 20% of the profits) ensures cash deposits or low-yielding bonds are not an investment alternative. To make the client, and themselves, money, they have to be in the stock market or something more risky than cash.
To persuade money managers to move their clients to cash, you need the likelihood of an event that will cause a 20% stock market fall, followed by a multi-year down trend: ie, a recession. That story is just not on the horizon, so no real risk to equities exists, other than a very short-term sell-off, which, most likely, will be followed by a strong rally.
And that is why volatility is so low and expectations are stable and steady. For investors, though, this low-volatile market may mean decent returns are going to be hard to find. Even though the global stock markets look okay, further meaningful gains may be in short supply over coming years.
Peter Brown is owner of
Baggot Asset Management (www.Baggot.ie) and head of education at www.IIFT.ie