The Volatility Bubble
For over a year there has been increasing talks on just how high this market can go.
Sound, fundamental investors are nervous for a good reason – nearly all traditional metrics point to this market being extremely overvalued.
However the market keeps chugging along, why is this?
The reason is because there is no one particular sector to blame. It is not like the dot-com bubble where technology stocks were the main culprit; it is not like the housing crisis where real estate was bubbling and mortgage defaults were popping.
This time, the whole market is overvalued pretty much the same across all sectors. Because there is no perceivable bubble looming, investors are all too comfortable pouring money into the currently overvalued market. The rock-bottom interest rates don’t hurt either.
People are questioning which bubble will cause the next market correction, crash, or even recession.
Remember that bubbles do not occur when people are expecting them. If people expect a bubble then it wouldn’t even form in the first place.
We must look outside the normal stock market chatter in order to understand what is currently bubbling and the reason behind it.
And that bubble is volatility.
Volatility (^VIX) is a complex calculation that is used to measure investor sentiment. As investors become more nervous on the future of the stock market, they begin purchasing S&P Put options and selling call options. This increase in option supply causes an expansion between the price of a Put option relative to a call option, and consequently, raises the volatility index (^VIX).
Last week volatility hit its lowest level since 1993, and it has barely recovered upwards and is still trading at unusually low levels.
This indicates a level of extreme complacency in investor sentiment – people just aren’t scared of the market and are willing to risk more and more money.
Investors aren’t the only ones to blame; the Federal Reserve has brought this onto themselves (and Congress to some extent), as the Fed has held the stock market’s hand since 2008.
The extreme amount of liquidity that the Fed injected into the market through its QE program, in combination with 0% interest rates, has increased the money supply to the point where consumer demand just isn’t high enough to outpace product supply.
When demand is less than or equal to supply, then prices fall or stay the same. And thus, inflation decreases, with the potential of deflation occurring.
We’ve seen this happen over the past 8 years – it’s the reason we’ve experienced the slowest recovery since the Great Depression. It was not a true recovery based on productivity increases, fiscal policies, or U.S. competiveness, but a mass injection of printed money into the economy to stimulate spending.
The end result is that businesses and individuals were encouraged to take on enormous amounts of debt at low prices (particularly the more naïve individuals), which they will be paying interest on their entire lifetime.
When people are using money to pay off debt, they aren’t consuming new goods or services. Subsequently this leads to demand decreases, lower company earnings, layoffs, then a recession or even depression.
The end result? We’ve spent trillions of dollars to push the 2008 recession further into the future, and in doing so made the resulting impact much worse than if we would have let the economy recover itself back in 2008. The more you coddle something, the less chance of its survivability when the coddling stops.
So this leads back to the Volatility Bubble. The longer that investors are nonchalantly putting money into the market, volatility continues scraping the bottom which encourages people pile into inverse volatility positions (shorting VXX or longing XIV).
We’ve seen this play out over the past few weeks. Short interest in the volatility ETN VXX has dramatically risen to a near 100%! This is insane when you think of the level of risk these people are taking.
An individual shorting volatility during the stock market’s little hiccup in August 2015 would have lost nearly half of their portfolio – and short interest back then was only 30%!
Imagine what would happen if the current market experienced another Augus