The hidden risks of a becalmed market

The great economist Hyman Minsky is best known for his view that “stability breeds instability”.

He might be worried if he took a look at our current market.

According to some measures, it’s so stable it’s practically horizontal…

One of the best investments over the past decade

One of the best investments in the world over the past ten years or so – delivering an 800% return – isn’t really an investment. It’s more of a state of mind.

The S&P 500 Vix Short-Term Futures Inverse Daily Index is the asset we’re talking about. The Vix index is sometimes known as Wall Street’s fear gauge. In effect, it looks at how much investors are willing to pay to insure their portfolios against big moves in the market.

When the Vix is high, it usually coincides with times of market turmoil. For example, the Vix index peaked at a level of just below 90 after Lehman Brothers blew up in 2008. As a rule of thumb, any reading above 30 tends to coincide with market distress. More typically, the index wobbles around the 20 mark.

However, volatility has diminished sharply in the post-2008 era. Central bank money printing has calmed investors’ nerves. The assumption has grown that there’s no problem that can’t be fixed with quantitative easing.

That’s why shorting the Vix – betting that it will go down in value over time – has been such a profitable bet (in theory, at least). Over the last two years or so in particular, it’s done very well indeed. Indeed, the Vix has been at or near a record low for several months now.

Now, there are various exchange-traded funds (ETFs) and other products that allow you to bet on the Vix. We largely avoid them because, like most ETFs that bet on a derivative index, it’s very easy to get tripped up by the mechanics of these funds (costs mount up when contracts roll over, the pricing is set daily, so the index value and the investment value can part company rapidly – they are complicated products).

So betting directly on the Vix is a niche area. And the fact that the Vix has hit a record low does not in itself mean anything. People argue about this a lot, but while a high Vix usually coincides with economic turmoil, a low Vix does not necessarily mean that turmoil is around the corner.

However, that doesn’t mean we can just dismiss it. We’ll come back to why in a moment.

Why stability breeds instability

But first, going back to good old Minsky for a minute, “stability breeds instability”. When people find a sure thing – an investment that seems to work all the time – their exposure just keeps on creeping higher.

They bet on it with more of their own money. They bet on it with borrowed money. They get greedy. Eventually, what was at one point an appealing strategy that made perfect sense when it first started to become popular, becomes overpriced.

It’s easier to see this with a share price. A share starts off unpopular and cheap, and when it gets too popular, it ends up being expensive. But it works for everything else as well. Specific strategies and styles of investing can become overly popular, too. And as they become more popular, they become much more risky.

The nice thing about an unpopular but fundamentally sound asset (and it’s fair to point out that uncovering the “fundamentally sound” part of the equation is the hard bit), is that it offers that all-important “margin of safety”. It’s been battered about so much already that there’s no one left to sell.

More importantly, even if the thing goes bust, hardly anyone will be holding on to it at that point. So the systemic damage is limited or non-existent. No one is betting their entire future on this particular bet coming good.

That’s not the case for much-loved assets or strategies. The key thing to grasp is that an increase in popularity also represents an increase in vulnerability. As a market becomes more expensive, it also becomes more fragile. When too many people are leaning over to one side of a boat, it doesn’t take much of a wave to tip it over.

And the problem is that, when it does, so many people have bet the wrong way, that it starts to cause problems elsewhere. Assets are forcibly liquidated to fund debt repayments, driving prices down further. Lenders panic about their own solvency and that of their clients.

Moral hazard and low volatility

What’s this got to do with the Vix? After all, betting on the Vix is a niche strategy, isn’t it?

It is. But betting on low volatility is not. As Harley Bassman points out at his website, The Convexity Maven, many popular investment themes and methods of building portfolio have “sell volatility” at their core.

These include the popular strategy of buying “low-volatility” stocks. Many “smart beta” funds offer the ability to bet on indices made up of such stocks, rather than the main index. And they’ve done very well in recent years.

The risk is that many people have piled into the “low-volatility” strategy without fully realising that “low volatility” is what underpins it. In other words, you have a group of investors who all think they’ve bought different things, but in reality, they’re all quite concentrated into one area of the market.

Again that means that when things go pear-shaped, it’ll go pear-shaped on a wider basis – and have wider-ranging effects – than anyone expects.

What could trigger the slide? There are always plenty of options, with the US Federal Reserve raising rates is an obvious one. But Bassman suggests that unexpected consequences of hurried tax changes in the US that change the treatment of debt in such a way that makes share buybacks look less appealing, could mark a turning point.

That all sounds possible. But the real point to learn is that you can’t attempt to take risk out of the market and expect it not to have any effect on investment decisions. The Fed’s attempts to bail out markets after every crash have been creating the conditions for ever-bigger crashes since the dawn of the post-war era.

Will we learn anything from the next Minsky moment? We can only hope.