As outlined in my February Review and last Friday’s Chart Book, I will look at certain risk markers, which we should monitor closely as euphoria keeps drumming the beat. My “Mosaic Theory” approach has already awakened my inner paranoid self, trying to figure out what and, more importantly, when things could allow for a shift change in markets. It might be futile, but I think it’s still worth going through the warning system occasionally.
I tend to do better in crises than outside of them; it's just how my brain and strategy work. I did well during the financial crisis and had one of my best months in March 2020. Yes, I missed a few, like the Chinese devaluation in 2015/16 and the inverse VIX ETF blowup and impact in 2018. Last year, my warning system went off when a bond trader friend highlighted unusual volumes in treasury futures on a Thursday afternoon. There was no news. I bought treasury call options that day. SBV then happened over the weekend. Similarly, in mid-2008 a friend and Libor and front-end focused ex-colleague of mine noted how Libor-fixings (yes, the possibly manipulated ones) had and unexpected high print all of the sudden. Being in warning system mode doesn’t mean one needs to jump at every small irregularity and hedge their books. It’s more about listening and observing more intensely than you normally would.
The interplay of fear and greed has long been a pivotal force shaping human behaviour, tracing its origins back to our very survival instincts. The amygdala is at the heart of this dynamic, a small but powerful brain area responsible for processing emotions, including fear and greed. The amygdala also projects, however, which explains how humans develop a certain auto-mechanism when similar external conditions appear. This is no different in markets where seasoned investors have that muscle memory of prior episodes. That’s why you can’t outlearn experience.
Leverage usually brings people back to reality. If you have ever played around with leverage, you will know its benefits but hopefully have learned its many dangers, too. If you haven’t, well, take your levered winnings and run. It is not difficult to look back at crises and see how leverage played a crucial role, especially in every financial crisis.
Lower volatility begets increased leverage. That’s how it works. To produce similar amounts of returns, you will have to take on more risk. Several volatility targeting concepts follow the same logic, thereby being short payoff convexity. It works and pays handsomely until it doesn’t. “Eat like a mouse, poop like an elephant” type of investing, as one of my former bosses opined.
I recount many senior investment management meetings in which we were asked whether we would be green (max. risk), amber (half risk), or red (min. risk) in terms of overall “heat” applied to portfolios. It’s funny how many times the collective (including me) would vote for green regardless of the level of potential risk, pointing out that there is "no risk” around. That’s how you get in trouble, my friends.
If lower volatility induces higher leverage and therefore fragility, let’s have a look at some of the markers we should consider when keeping our ears to the ground.
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