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“Animal Spirits” and Trader Induced Volatility

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"Animal Spirits" and Trader Induced Volatility

Written by: Saumen Chattopadhyay

At the core of Convex’s investment process, we believe macroeconomic fundamentals and business cycle trends indicate changes in asset prices in financial markets. We evaluate economic environments of thirty countries around the globe based on leading economic indicators which results in a proprietary leading economic index and monthly risk rating for each country. Our risk management functions entail

  1. De-selecting  countries with sub optimal growth (and higher vulnerability to risk) and selecting countries with in-line or above average growth using trend nowcasting that is reflected in our monthly risk rating,
  2. Dynamic Volatility Adjustment (DVA) using proprietary analysis to avoid risk assets with higher volatility in a strive to provide much less portfolio volatility in disruptive markets, and
  3. Analysis of ‘Known-Unknown’ risks with event-based scenario analysis following a game theory approach to reduce vulnerability to ‘tail-risks’.
     

Convex’s Dynamic Volatility Adjustment (DVA) is interwoven with our fundamental assessment of economic conditions as opposed to using volatility as a momentum or market timing tool. Market timing is the strategy of attempting to predict future price movements using various fundamental and technical analysis tools. Extreme market timers are often algorithmic traders, who move in and out of positions in seconds. Market timing is considered more of a gambling than a legitimate investment strategy. Unfortunately, stock price returns closely resemble a ‘random walk’ where movements are not always logical or easily predictable. It is also important to keep in mind that stock prices go up and down due to unexpected exogenous events, which cannot be predicted using any fundamental or technical analysis.The movement of financial markets however, reflects the current and expected state of economy. As economy goes through different stages in the business cycle, so do the markets. The behavior of financial market is distinctly different when business cycle goes through different stages e.g. initial recovery, early upswing, late upswing, slowdown and recession. Empirical evidence suggests that when an overall economy goes into recession, volatility rises and the stock market declines over a sustained period of time. The key choices faced by investors are essentially two-fold. First, the consumption-saving choice is the decision about how much wealth to allocate to current consumption and how much to save for future consumption. Second, the portfolio selection choice represents how to allocate the savings among all the investment opportunities. In this intertemporal approach, risk premiums could vary over time in order to match varying business conditions.

The real anomaly comes from excess market volatility, which some academicians defined as “animal spirits” or “bandwagon effect and arbitrary feedback relations” or mass psychology. The behavior of volatility during an environment when fundamentals are weak could be different from volatility-clustering as a natural result of price formation process with heterogeneous beliefs across traders. This volatility-clustering is not attributable to autocorrelation around public information e.g. macroeconomic news or firms’ earning releases. Long term investors naturally focus on long-term behavior of prices, whereas traders aim to exploit short-term fluctuations. While fundamentalists expect that the price reverts to the fundamental value over the long run, noise traders try to identify price trends, which results in herding since traders often use price and volatility as signals when placing orders. Noise traders evaluate their performance according to realized trade gains, whereas for the fundamentalists, performance is measured according to the difference between the price and the fundamental value. The market volatility driven by noise traders is what we call “trader-induced volatility”, which may not be associated with other stylized properties of volatility such as clustering at the onset of a sustained bear market, when risk-reward trade-offs can be turned on its head. The spike in volatility induced by noise traders is considered a ‘volatility jump’, which may not persist with a level of significance. This ‘volatility jump’ is different from changes in volatility clustering with a degree of persistence as seen in sustained bear markets, including 2007-08 when there was a flight to safety. With the demise of Bear Stearns and Lehman Brothers, and The Reserve Fund breaking the buck, all of these along with the macro shocks caused a tremendous panic wave among a large group of investors. The heightened level of volatility around this time persisted which caused risky assets lose money and riskless assets make money.

Related: Five Macro Questions for 2018 Investors

Choppy market corrections that are not associated with fundamentals but “trader-induced volatility” are very normal. They are typically short-lived and do not represent a shift to new market paradigm. The recent market decline in February, 2018 based on traders’ worries of an overheating economy, with wage inflation peaking to a level that can lower operating margin and faster than predicted rate hikes by the Fed in response, is rather incongruous with the economic picture in the US. Our proprietary risk rating for the US currently stands at Hold-Buy, on the back of strong economic data, accommodative fiscal policy and a Federal Reserve that is only gradually raising interest rates. While the latest employment report showed a significant pickup in wages, this is only one data point and we do not anticipate this to feed into inflation immediately. Headline inflation was more or less unchanged at 2.1% in 2017, buttressed by a pickup in food and energy prices. Core inflation, which excludes food and energy, actually fell in 2017 and if anything, this is not indicative of an immediate surge in inflation. The overall risk rating for the world also stands at Hold-Buy, with strong economic data in the United States and across the developed world (especially in Europe), and improving figures in Emerging Markets.

The year 2018 started with a positive note as the markets ran up on the expectation of increased profit margin due to significant reduction of corporate taxes in the US and now the market is experiencing a spike in volatility due to concerns of squeezing profit margin as a result of wage inflation and slowdown from restrictive monetary policy. The reality is that the economic backdrop now in the US and across the globe is far more favorable than the last time markets suffered a volatility-induced collapse, including the summer of 2015. Our fundamental research gives us confidence to stay the course and not react to “trader-induced volatility”, and get whipsawed. We continue to monitor economic prospects of thirty different countries across five regions of the globe. We also remain vigilant about persistence of volatility change and potential known-unknown risks.

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