Eric Peters On Tipping Points: “It All Worked Incredibly Well, Until It Blew Up”

October 1, 2017
mm

Two years ago, long after we first suggested that the transformation of VIX from a measure of implied market volatility to a reflexive instrument that can be traded – and thus influence the underlying assets whose volatility it was supposed to measure – allowed the VIX to serve as the “fulcrum security” for broad asset manipulation, first the FT, then the WSJ confirmed what we said, namely that pervasive market manipulation was not only possible, but took place on a regular basis, courtesy of the VIX (see “Conspiracy “Fact” – VIX Manipulation Runs The Entire Market” and “Another Rigged Market: Scientific Study Finds Systemic VIX Auction Manipulation“).

Today, one of our favorite hedge fund commentators, One River Asset Mgmt CIO Eric Peters, discussed various market “tipping points” in his latest weekly notes, which emphasized why volatility is no longer a “measurement”, as much as a “target.” More his latest Sunday anecdote:

“When a measure becomes a target, it ceases to be a good measure,” said the Englishman, stepping outside of himself.

“That’s Goodhart’s Law.” Charles Goodhart observed that central banks measured money supply, and found certain M1 growth rates to be optimal. But once they targeted that optimal range, M1 lost its value as a measure.

Market and economic actors adjusted their behavior to game the M1 system. So central bankers shifted to M2, then M3, and M4.

“Investing is obviously not a science, but if it were, we would say that you can’t act on something and observe it at the same time.” French colonialists discovered this in rat infested Hanoi, when they offered a bounty for killing rodents. To receive the reward, the Vietnamese were required to produce severed tails. Soon thereafter, tail-less rats scurried throughout the city. The bounty hunters removed their tails and released them to the filthy sewers to breed. Boosting their bounty.

“Investors discover pricing anomalies from the past. And they pile into them, ensuring that for a time they persist.”

They mistake the distortions of their wall of money for the wisdom of their observations. They interact with the market as if they’re exogenous, when, in fact, they’ve become endogenous.

“Today’s greatest example of Goodhart’s Law in action can be found in volatility markets.”

The VIX index measures the expected volatility of the S&P 500, and is calculated by multiplying expected 30-day variance by 100.

As a measure of market fear, it was quite useful, until it became something that could be traded. “The sheer size of outstanding positions in VIX futures, VIX options, ETFs, ETNs and bank volatility selling programs is such that those trading these markets can no longer separate the true measure of volatility from their own actions.”

Or, said simpler, “low volatility” is no longer a description of a market state, rather it is a characterization of the one, and perhaps only, trade strategy that has the explicit blessing of central banks, who themselves do everything in their power to crush volatility as Deutsche Bank’s Aleksandar Kocic explained yesterday in his latest observations of a market in which “shocks no longer shock.”

It is also why average September vol was the lowest on record, and will continue to fall until a “tipping point” hits.

It is also why, as Barclays pointed out last week, as absolute notional Vega across levered and inverse ETFs reached an all time high…

… the AUM in inverse VIX ETPs has soared over the past few months and is now in line with long vol ETPs, a situation which has previously occurred only twice since 2009, and as we noted, the only two previous occasions when the AUM of inverse ETPs caught up with their long peers, was after the October 2014 Ebola scare and right after the August 2015 ETFlash crash, when vol sellers emerged after the VIX surge (and when VIX was briefly halted for dissemination on August 24, 2015 when the market literally broke).

And speaking of tipping points, here are some further observations from Peters on this topic, first, through the lens of the quant blow up in the “Summer of 2007″…

The statistical arbitrage models had made such strong returns. But as money flowed in, their Sharpe ratios declined from exceptional to great. Then great to good. So on, so forth. But by doubling leverage the Sharpe ratios could be magically restored to their former glory. Doubling leverage required doubling positions, which in turn supported prices, and this lowered volatility – producing strong profits without an appearance of an increase in risk. And that all worked incredibly well, as of course it should, until it blew up.

… then, the Merrill convertible arb “Percent Cheap” fair value model:

Merrill produced a measure called “Percent Cheap.” It allowed you to monitor where convertible bonds traded in relation to fair value. The measure explained the profitability of convertible arbitrage strategies throughout the cycle. The strategy was profitable, consistent. As money flowed in, the funds swelled, until the assets of all convertible arbitrage funds multiplied by their leverage equaled more than the sum of all global convertible bonds. Returns naturally declined to zero. Turned negative. Sparking small redemptions. Then it all imploded.

… a curious look at unexpected feedback loops involving cobras in India…

The British Raj grew concerned by the abundance of venomous cobras in Delhi. A reward was offered for every dead snake. And in they slithered. One by one at first. Then in baskets, barrels. “Our strategy has proved a great success,” announced the Raj, yet still the number of captured cobras swelled. You see, the breeders had entered the business. When Raj learned of this betrayal, the law was abruptly abandoned. And the captive snakes, as worthless as they were abundant on a scale never before seen, were set free. Coiled throughout Delhi.

… and finally through the (imminent) folly of the Swedish Central Bank:

“The objective of monetary policy is to maintain price stability,” declared the Sveriges Riksbank Act. Stability is defined as 2% inflation, itself an oxymoron. “Sustainable growth and high employment are to be supported,” says the Act, though they’re of secondary importance. Inflation is now at the 2% target, a consequence of overnight interest rates at -0.50% and central bank bond buying, which weakened the krona, sparked +5.3% IP growth, +4.1% services output, unprecedented real estate speculation, and surging consumer debt.

Article Categories:
Financial Economics Blogs

Leave a Comment

Your email address will not be published. Required fields are marked *