Weekend Reading: Volatility Returns With A Vengence

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Ironically, last week I titled last week’s reading list “Market Stasis” with respect to the 43-days of sideways market action with relatively minor price fluctuations. That publication marked the respective end of that complacency.

This past week has been anything but complacent as the volume in volatility trades have exploded simultaneously with wild swings in market price from spectacular declines to surging rebounds.

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This corrective action, which I have warned about repeatedly over the last month (see here) may be different than the standard “buy the dip” correction. The market has already violated both initial supports (the bull trend line and previous highs) which brings into focus the bull trend support line from the February lows. A violation of the latter will likely see the markets retest the 2020 level on the S&P 500.

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One thing the sell off this week showed investors is what happens when correlations across asset classes become extremely high. When the selling begins, there is no “safe place” to hide. As my partner, Michael Lebowitz, noted earlier this week:

“The truth of the matter is that blind diversification does not work simply because it does not take into account the effects of volatility on asset prices. Chris Cole from Artemis Capital, one of the clearest thinkers on the importance of volatility as an asset class, highlights this point in the following graphic.”

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“Contrasting the perception of a well-diversified portfolio with the reality of embedded volatility, the graph reflects enormous concentration risk in short volatility. Importantly, this risk matters most at the exact point in time when one expects – hopes – their strategy of diversification will protect them. Unfortunately, the well-diversified portfolio (left side) turns into the short volatility-concentrated portfolio in periods of extreme market disruption. Mr. Cole’s analysis may be best summarized with the popular statement that correlations on many assets go to one during a crisis.”

Let’s put it this way. If you didn’t like what happened to your portfolio this week during a mere 3% decline from recent peaks, just imagine what you will be feeling when a correction of some magnitude eventually occurs.

It is at this point, when individuals stare into the “abyss,” the realization of the “risk” they have undertaken becomes most apparent. It is also when the mantra of “I bought it for the dividend” changes to religion as the prayers are lofted for a “bounce to get out.” 

This is why I focus on risk and the inherent management of it. The returns will take care of themselves.

But, in the meantime, here is what I am reading this weekend.

Fed / Economy

 

Markets

 

Interesting Reads

 

“A fool and his money are lucky enough to get together in the first place.” — Gordon Gekko (Michael Douglas) Wall Street

Questions, comments, suggestions – please email me.