Investors Have Fallen Into a False Sense of Security

25In January 2018, two significant market events occurred nearly simultaneously. Major U.S. stock market indexes peaked and volatility indexes extended one of their longest streaks of low volatility in history. Investors were happy, complacency ruled the day and all was right with the world.

Then markets were turned upside down in a matter of days. Major stock market indexes fell over 11%, a technical correction, from Feb. 2–8, 2018, just five trading days. The CBOE Volatility Index, commonly known as the “VIX,” surged from 14.51 to 49.21 in an even shorter period from Feb. 2–6.

The last time the VIX has been at those levels was late August 2015 in the aftermath of the Chinese shock devaluation of the yuan when U.S. stocks also fell 11% in two weeks.

Investors were suddenly frightened and there was nowhere to hide from the storm.

Analysts blamed a monthly employment report released by the Labor Department on Feb. 2 for the debacle. The report showed that wage gains were accelerating. This led investors to increase the odds that the Federal Reserve would raise rates in March, June and September (they did) to fend off inflation that might arise from the wage gains.

The rising interest rates were said to be bad for stocks because of rising corporate interest expense and because fixed-income instruments compete with stocks for investor dollars.

Wall Street loves a good story, and the “rising wages” story seemed to fit the facts and explain that downturn. Yet the story was mostly nonsense.

Wages did rise somewhat, but the move was not extreme and should not have been unexpected. The Fed was already on track to raise interest rates several times in 2018 with or without that particular wage increase. Subsequent wage increases have been moderate.

The employment report story was popular at the time, but it had very little explanatory power as to why stocks suddenly tanked and volatility surged.

The fact is that stocks and volatility had both reached extreme levels and were already primed for sudden reversals. The specific catalyst almost doesn’t matter. What matters is the array of traders, all leaning over one side of the boat, suddenly running to the other side of the boat before the vessel capsizes.

The technical name for this kind of spontaneous crowd behavior is hypersynchronicity, but it’s just as helpful to think of it as a herd of wildebeest that suddenly stampede as one at the first scent of an approaching lion. The last one to run is mostly likely to be eaten alive.

Markets are once again primed for this kind of spontaneous crowd reaction. Last week the Dow recorded its first record high since January. The S&P and Nasdaq are also firing on all cylinders. Good times are here again and investors have gotten complacent, just like earlier this year.

Except now there are far more catalysts for a sharp market selloff.

We all know about the trade war with China, which shows signs of worsening, if anything. But look at the potential trouble from geopolitical sources alone…

The U.S. has ended its nuclear deal with Iran and has implemented extreme sanctions designed to sink the Iranian economy and force regime change through a popular uprising. Iran has threatened to resume its nuclear weapons development program in response. Both Israel and the U.S. have warned that any resumption of Iran’s nuclear weapons program could lead to a military attack.

Three faces of volatility, from left to right: Ayatollah Ali Khamenei, the spiritual and de facto political leader of Iran; Nicolás Maduro, the president of Venezuela; and Kim Jong Un, the supreme leader of North Korea. Iran and North Korea may soon be at war with the U.S. depending on the outcome of negotiations. Venezuela is approaching the status of a failed state and may necessitate U.S. military intervention.

Venezuela, led by the corrupt dictator Nicolás Maduro, has already collapsed economically and is approaching the level of a failed state. The people have no food. Inflation has risen about 200,000% over the past year and the IMF estimates it will reach 1,000,000% by the end of the year. Its inflation rate now greatly exceeds the hyperinflation of Weimar Germany.

Social unrest, civil war or a revolution are all possible outcomes. If infrastructure and political dysfunction reach the point that oil exports cannot continue, the U.S. may have to intervene militarily on both humanitarian and economic grounds.

North Korea and the U.S. have pursued on-again, off-again negotiations aimed at denuclearizing the Korean Peninsula. While there have been encouraging signs, including last week’s pledge by Kim Jong Un to work towards a non-nuclear future, the most likely outcome remains that the North Korean leader is playing for time and dealing in bad faith.

The U.S. may yet have to resort to military force there to negate an existential threat.

This litany of flash points goes on to include Iranian-backed attacks on Saudi Arabia and Israel, U.S. military intervention in Syria, (which could accidentally target Russian forces), confrontation in the South China Sea and Russian intervention in eastern Ukraine.

These traditional geopolitical fault lines are in addition to cyber threats, critical infrastructure collapses and natural disasters from Kilauea to the Congo.

Investors have a tendency to dismiss these threats, either because they have persisted for a long time in many instances without catastrophic results, or because of a belief that somehow the crises will resolve themselves or be brought in for a soft landing by policymakers and politicians.

Investors expect that the future will resemble the past, that markets move in continuous ways and that extreme events occur rarely, if at all. These beliefs are good examples of well-known cognitive biases such as anchoring, confirmation bias and selective perception.

These assumptions are all false.

The future often diverges sharply from the recent past. Markets gap up or down, giving investors no opportunity to trade at intermediate prices. Extreme events occur with much greater frequency than standard models expect.

When they do strike seemingly from nowhere, like fire in a crowded theater, everybody panics and a wave of selling feeds upon itself.

Even if the probability of any one event blowing up is low, when you have a long list of volatile events, the probability of at least one blowing up approaches 100%.

With this litany of crises in mind, each ready to erupt into market turmoil, what are my predictive analytic models saying about the prospects for an increase in measures of market volatility in the months ahead?

They’re saying that investor complacency is overdone and market volatility is set to return with a vengeance. Again, changes in VIX and other measures of market volatility do not occur in a smooth, linear way. The dynamic is much more likely to involve extreme spikes rather than gradual increases.

This tendency toward extreme spikes is the result of dynamic short-covering that feeds on itself in a recursive manner — or what is commonly known as a feedback loop.

Shorting volatility indexes has been a very popular income-producing strategy for years. Traders sell put options on volatility indexes, collect the option premium as income, wait out the option expiration and profit at the option buyer’s expense. It’s been like selling flood protection in the desert; seems like easy money.

The problem is that every now and then a flash flood does hit the desert.

When we consider recent financial catastrophes affecting U.S. investors only, without regard to other types of disaster, we have had major stock market crashes or global liquidity crises in 1987, 1994, 1998, 2000 and 2008.

That’s five major drawdowns in 31 years, or an average of about once every six years. The last such event was 10 years ago. So the world is overdue for another crisis based on market history.

The trouble is, most investors will never see it coming.

Regards,

Jim Rickards
for TheDaily Reckoning