The last month has been uncertain and uncomfortable for investors. As measured by the VIX volatility index, a barometer of investor expectations for future market moves, volatility has just had its biggest spike since June. And while volatility has – and always will have – its place in the markets, the context of our current conditions makes this scenario scary.
Quite simply – the market is very poorly equipped for even more volatility.
New year, new narrative
The new year has brought with it the early stages of a multiyear growth and value rotation. After a lengthy period of US exceptionalism, which saw dollar strength reflexively suck cash into US markets, US valuations are stretched.
We’ve been talking about this for months. There are bloated valuations everywhere which will undoubtedly have broad market implications. By our estimates, US stocks are overvalued by around 9%. What’s more, momentum names, including Apple, Microsoft, Amazon and Nvidia, have stopped performing. Despite this, people are still investing. It is this divergence which brings with it both the risk and need for correction, which ultimately has the power to ricochet worldwide.
When challenging convention is confused with cynicism
The late Sir John Templeton once said: “Bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria.” While correct in sentiment, this statement forgets that challenging convention is not the same as cynicism.
Macro analysis provides an opportunity for investors to understand broad market trends and implications. When there is a reversal of a multiyear trend, or a significant change, it’s often hard to believe, because people don’t want to believe it. It’s all in the name – reversal. It usually occurs when we’re all-in; heavily invested and fully committed. It makes it easy for the majority to dismiss these new narratives and ideas as pessimistic. The result is a point in rotation where the risk of instability rises as different themes and ideas start to compete.
This game must stop
The knock-on effect is a market being driven by a flow of capital rather than market fundamentals and macroanalysis. The GameStop trading of January is an example of this. It’s too easy to dismiss this as a rare David and Goliath moment. In reality, it’s a group of speculative retail traders, who don’t have any philosophy about valuation, manipulating the market with capital first. As a result of this Reddit-inspired binging, GameStop’s stock went on a wild ride.
Let’s not forget, we’ve seen this before. Last June, Hertz Global Holdings Inc.’s stock experienced comparable soaring demand, based on similar musings and valuations. The company sold $29 million of stock, despite actually being in bankruptcy, before The Securities and Exchange Commission halted activity. Unlike Hertz, GameStop is not under bankruptcy protection.
Then comes correction
For GameStop, correction is already in play. In the first week of February, its shares have collapsed 84%. This follows the 25-fold surge of the previous month. Again, we’ve seen this before. In 2018 we saw volatility explode – short volatility funds got caught in a negative gamma vortex that was subsequently known as “Volmageddon”. Many huge investors took hits on their portfolios, some people lost it all, a few got lucky. This led to significant market correction.
This time however, the pain is being felt especially hard in the long/short community. What makes this particularly toxic is that it is meant to be a low volatility, hedged strategy. As a result, their models are not designed for these current moves, and the losses are potentially staggering.
Securing and stabilising the markets
While ground zero is different this time around, we are increasingly cautious on the markets – acknowledging the outstanding shares in the VIX ETF (VXX) are above where they were just before last February’s VIX explosion. Events are unfolding rapidly, and we are leery of taking a strong stand on stocks until we can fully understand the big picture. In the meantime, we will continue to watch bonds and FX for signs that the winds are changing.