Effective Date:  May 13, 2022

VOLATILITY TRAPS

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Following the 2008-2009 financial crisis many large investment firms such as family offices, hedge funds, and banks began using risk management models intended to keep them from being destroyed by market volatility. The Federal Reserve Bank requires banks such as JP Morgan, Citibank and Goldman Sachs to use value-at-risk models (VAR) in determining their capital requirements. VAR models use several inputs to calculate the potential loss to a portfolio in a day, week, or month. These inputs are dynamic, so when market volatility picks up, the calculations can change dramatically. While this does not necessary apply to normal banks, some investors like hedge funds and family offices began using VAR type calculations to increase risk. (aka VAR based investors.)  For example, when volatility is low, and VAR calculations indicate portfolio risk is below what they can tolerate, they use leverage or some form of borrowing to increase the size of their holdings, amplifying their returns. While many of these funds use similar strategies, they all are different and during calm times, like last year, slowly add leverage.

 

The problem arises when volatility increases quickly and stays elevated for some time. This leads to a “volatility trap”. When market volatility increases quickly and stays elevated for a long period of time, funds using VAR strategies to manage risk become forced sellers regardless of price. It is important to note that not every decline leads to a volatility trap and it takes time, perhaps a month or more, for a correction to become a true volatility trap. This is because many VAR calculations use short-term averages or trends as inputs. A one day sell off on bad news that bounces back in a day or two would be generally ignored by VAR calculations. Here is how a volatility traps play out:

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• An event triggers a negative market reaction and increase in market volatility. Markets may bounce back some, but volatility remains elevated.

• VAR based investors begin reducing leverage in portfolios by selling down positions. This is called de-risking and de-leveraging. Market losses accelerate and the declines seem out of proportion to the original news evert.

• The selloff spreads to short-term investors and DYI type investors. The original catalyst is attributed to the decline. Markets decline further and volatility stays elevated. 

• The financial media (CNBC & Bloomberg, etc.) sell advertising to make money. Their ratings are directly correlated to market volatility. The higher the volatility, the higher their ratings, the more money they make. Whether intentional or not, the financial media contributes to volatility during times of uncertainty.

• Market recoveries in early stages of a volatility trap are sold as VAR based investors are still trying to reduce their gross expose and re-risk. Retail and DYI traders that bought the original dip, capitulate and sell or stop buying further declines. Markets open higher and close lower on a daily basis, seemingly for no reason.

• Margin calls (forced liquidation to reduce leverage) and eventually underlying investors in VAR based models (clients of the hedge fund) begin asking for their money back, further reducing portfolio size, leading to more selling.

 

In short, there becomes a supply and demand imbalance in markets. There are many willing sellers to sell at nearly any price because they are forced, and few willing buyers to step in with new capital. Note that most long-term investors are fully invested most of the time up to their risk appetite levels. So long-term investors do not step in to stabilize the markets during a volatility trap. The following is a chart that shows what a volatility trap looks like as it plays out.  Each line is a 30-minute time period and it covers the month of May 2022. There is no official description of volatility traps, but since the financial crisis of 2008-2009, there have been five time periods, with the two most recent being the fourth quarter of 2018 (caused by a Fed policy pivot) and the COVID correction in March 2020. 

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Volatility traps usually resolve one of two ways. The first is that eventually the forced selling caused by VAR based investors dries up as they have reduced their portfolios to a size consistent with the level required by their VAR calculation and their underlying investor liquidations are met. All of the short-term market timers that are going to sell have sold or have given up buying the dip are in cash. In short, the market supply and demand drifts back into balance. The second way they resolve is there is a new catalyst (news event) that negates the original reason for the decline. In this case, markets have likely already stopped declining and the recovery is swift as those who sold rush back in. Then the cycle begins again, because as volatility initially stabilizes and then declines, the VAR based investors start buying again and adding leverage back into the system.

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CURRENT SITUATION

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It can take time for a volatility trap to evolve, but the market dynamics the last few months seem to fit the description.

• The initial catalysts for the current volatility trap were the Russian invasion of Ukraine and the Fed Policy Pivot. Interestingly, they are related and they began to impact the markets at about the same time. They are related because the invasion caused a surge in energy and food prices, impacting inflation and expediting the Fed Policy Pivot.

• Daily volatility since the invasion has been significantly above normal and higher than it has been since the early days of the COVID correction. Sustained periods of elevated volatility has led to liquidation of leveraged portfolios.

• Both the stock and bond markets are down more than 10% year-to-date, which is unusual.  Often when the stock market has a correction, bonds perform well.  That is not the case with this correction, nor was it the case in the fourth quarter of 2018, one of the more recent volatility traps. The fact that both stocks and bonds are both down has prevented long-term investors and target date funds from selling bonds to buy beaten down stocks. This is important because investors like target date funds have become a major market stabilizing mechanism.

• The current declines in the stock market and bond market have put significant pressure on two specific types of leveraged investors. One of the largest hedge fund strategies is called “risk parity” and it is the main strategy of the largest hedge fund manager in the world, Bridgewater. This strategy involves leveraging up a bond portfolio to roughly equate the risk of a stock portfolio. The current decline in bonds is forcing liquidation of levered bond portfolios which also leads to it simultaneously reducing their stock portfolios.

• The second group of investors under pressure is technology focused funds and retail investors. The rise in interest rates has led to larger losses in tech stocks than the overall market. Many large funds have leveraged positions in technology stocks and are being forced to liquidate due to the declines in these stocks. An example is Amazon, which is a large holding of many investors and the stock is down 37% since the beginning of April.

• Typical investors do not use leverage or options, but they are also feeling the pain and despair of the current downturn. According to recent sentiment surveys, investor optimism about the future is at the lowest point since the early 1990’s. This is surprising when you compare the world today to the days just after 9/11, during the depths of the financial crisis, or global COVID pandemic. This level of despair seems misplaced and overly negative.

• Markets have had several failed rally attempts, opening higher only to sell off later in the day on no news. It appears buyers of the dip have given up and everyone has become negative about the market.

 

 

NEXT STEPS

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It is probable the current volatility trap ends like most of the traps of the past. Eventually, the forced selling and de-risking comes to an end as leveraged positions reduce to a new sustainable level. The market returns to equilibrium of supply and demand. A second possibility is that a new catalyst will occur such as the Fed more explicitly lays out its interest rate policy path or the war in Ukraine reaches some sort of negotiated settlement. It is not possible to know when or how the volatility trap will end, but it will end eventually.

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These are frustrating times for long-term investors because they know periods like this happen and the future is likely to be better. However, it is difficult to stay positive and focused on the long-term when so many others are negative and focused on the near-term. The silver lining is that in the past when there have been extreme levels of negativity it was also a good time to invest. The best course of action for most investors is to do nothing and wait for the volatility trap to burn its self out. If you have excess cash, now is likely a good entry point for long-term investing. 

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