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Volatility and the Alchemy of Risk (2017) [pdf] (static1.squarespace.com)
37 points by kaycebasques on Feb 19, 2018 | hide | past | web | favorite | 12 comments

We're living through an unprecedented global experiment, wherein central banks manipulate interest rates in order to encourage investment. The reasoning (as I understand it) is that if companies can borrow money with low interest rates, they're more likely to invest. By the looks of stock prices, this strategy appears to be working. But when you look under the hood, it's mostly self-serving financial engineering, at an unprecedented scale. As the article points out, companies use the cheap money to manipulate their share prices. This isn't real investment.

"The later stages of the 2009-2017 bull market are a valuation illusion built on share buyback alchemy. Absent this accounting trick the S&P 500 index would already be in an earnings recession."

"Rather than investing to increase earnings, managers simply issue debt at low rates to reduce the shares outstanding, artificially boosting earnings-per-share by increasing balance sheet risk, thereby increasing stock prices."

"Share buybacks have accounted for +40% of the total earning-per-share growth since 2009, and an astounding +72% of the earnings growth since 2012."

>We're living through an unprecedented global experiment, wherein central banks manipulate interest rates in order to encourage investment. The reasoning (as I understand it) is that if companies can borrow money with low interest rates, they're more likely to invest. By the looks of stock prices, this strategy appears to be working.

Investment actually seems to be quite low right now by most metrics, relative to the supply of capital seeking investment opportunities. See, e.g., [0] (2017)

Also, as I’m sure you might expect, the reason behind high stock valuations is more complex than this. Notably, stock represents a claim on future cash flows, and lower interest rates mean that the expected present value of those cash flows is higher when all else is equal. Highly recommended reading related to this: [1]

[0] https://www.brookings.edu/articles/secular-stagnation-even-t...

[1] https://johnhcochrane.blogspot.com/2018/02/stock-gyrations.h...

I’m with you. I didn’t mean to imply that investment is actually high. I just meant that by the looks of stock prices, one might suppose that investment is high. From what I understand, the central bankers hoped that flooding the markets and driving down interest rates would force investment into the real economy (for lack of yield anywhere else), but that doesn’t appear to be actually happening.

“The danger is that the multi-trillion-dollar short volatility trade, in all its forms, will contribute to a violent feedback loop of higher volatility resulting in a hyper-crash. At that point...there is no theoretical limit to how high the volatility could go."

"[This could happen] if inflation forces central banks to raise rates into any financial stress."

Just in case anyone thought this sounded boring.

In case anyone wants to listen to the recent podcast: https://www.macrovoices.com/360-chris-cole-volatility-and-th...

And if you don't recall... two index funds, XIV and SVXY got saw their combined value shrink to $150 million from $3 billion in a day of trading earlier this month. It looks like this was written in Oct 17.

Yes, one of the founders of Artemis says in this article that they had been positioning themselves for an event like the collapse of SVXY for a long time.

Thiel Macro (Peter Thiel's personal investment firm) apparently was also well-positioned for the event.



P.S. that Guardian article is doing the typical sensational journalism thing of framing Artemis as profiting off of others' misery, and here's Artemis' official response:


I don't blame them for extrapolating the likely consequences of central bank recklessness, and positioning themselves accordingly.

Yes but the paper goes well beyond that. E.g. there's the stuff on share buybacks, which have accounted for 30% of stock market gains since 2009, and 72% of earnings-per-share growth since 2012.

That was very well-written.

I don't think it was well written.

It follows a bunch of cliches from HF notes (e.g., pointless references to classic mythology and random hand-wavy macro issues). They assert a bunch of things, surround it with some facts but the overall logic is loose. There are some reasonable points here and there which lend some sense of reasonableness. But that is all a DISTRACTION.

The general goal being to give the impression of big-picture thinking when the punchline is usually A TWEAK OF SOME LONG WORN OUT STRATEGY.

Lets cut through this.

The tweaky strategy here in this case is the chart at the very end showing 50/50 mix of SP500 + Eureka hedge long vol HF index. The combination of outperforms the SP500 significantly in overall return (and in risk adjusted space). I.e., you should buy some of our HF (or your own long vol) and then also buy SP500.

The problem is long vol HF index has a ton of issues and is basically junk. It is not something you can practically replicate with long vol instruments and get anything similar in terms of performance. Additionally, a major part of the index is 2 Bridgewater funds which have fantastic performance over the period in question (especially the 3-4 years post crisis) and those Bridgewater funds are certainly NOT long volatility strategies. They are global macro. It is just constructed in a dumb way and is basically fiction. The firm that wrote the note didn't construct the index but they did select it for their comparison, so bad on them.

The classic problem with these long vol strategies is that you pay a ton of money month over month to get the return when vol picks up. And despite these strategies being generally diversifying, the performance drag kills you over time. People have looked at these strategies across many time periods, many geographies and they generally don't work. Likewise, many tail risk strategies that rely on buying options don't work well either (they can work OK under very particular conditions).

I mean, it's full of academic journals such as Zero Hedge in its references.

But I didn't read it as advocating a long vol strategy as pointing out the meta problem with short vol. Someone who has thought and written much deeper on similar issues is Elie Ayache. But Ayache is full on unreadable and kind of aims for a "Derrida of finance" role.

This note, in contrast, was very well written.

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