There's Nowhere To Hide

| About: SPDR S&P (SPY)


What happens when nothing works as a hedge?

Has the combination of central bank largesse, risk parity proliferation, and rising correlations set the stage for a rout?

Spoiler alert: probably.

Do you remember August 24, 2015?

I do. It was a decidedly bleak affair. A "Black Monday," to use the cliche.

Global markets were reeling from China's "surprise" yuan devaluation (I put the word "surprise" in quotes there because one look at the trade-weighted RMB was all you needed to discern that they were going to have to devalue eventually) and thanks to a horrific overseas session and some nefarious combination of HFTs, ETFs, and sheer panic, the Dow fell 1,000 points out of the gate. Here's a look back at the carnage:

Click to enlarge

Or, put more succinctly:

I remember chuckling to myself thinking of all the poor souls who swore by ETF liquidity as prices became completely unhinged vis-a-vis NAVs. But that's a topic I've discussed elsewhere ad nauseam, so I'll leave it for now.

But you know what else I remember? I remember an FT article published the day before, on August 23. It cited a study by AllianceBernstein. Here's a quote from that report:

Should correlations turn positive, with stocks and bonds declining at the same time, the risk contribution of each one would rise. [Risk parity] managers would then have to sell both to maintain their risk targets. In other words, selling begets selling.

In a sign of the times, Ray Dalio's "All Weather" fund was caught out in the rain with no umbrella. It fell 4% in August. Some blamed risk parity strategies for exacerbating the turmoil. Here's how JPMorgan's "superstar" quant guru Marko Kolanovic put it earlier this year:

[The] diagram shows a hypothetical performance of 2 assets: one with positive momentum and another asset whose price declined below some long-term valuation level. As the price of the trending asset increases, its volatility declines. Similarly, the volatility of the 'value' asset increases as the price moves lower. Based on this pattern, most risk models would increase the weight of the trending asset and decrease the weight of the value asset, reinforcing the divergence. Many systematic strategies (such as CTAs, Risk Parity/Vol Target, Low-vol Risk factor portfolios) would do the same. The positive feedback between inflows and low volatility eventually increases the crash risk for trending assets.

(Chart: JPMorgan)

Dalio defended the strategy in a September report. Personally, I couldn't care less what role algorithmic trading and/or technical selling played in the downdraft. What interests me is how this plays out when both stocks (NYSEARCA:SPY) and bonds are overvalued. Here's what Deutsche Bank said in the lead up to the September Fed meeting:

A 'policy error' rate hike might well result in positive correlations among equities, commodities and bonds, due to a combination of risk off and higher rates. In this case it is not entirely clear how risk-parity funds would rebalance: A potential candidate for inflows would be currencies, and in particular the dollar, which could be the only game in town. Of course, this would only put additional upward pressure on the dollar, reinforcing the 'policy error' nature of the hike via additional traded goods price deflation (including commodities), weakness in net exports, and exacerbating pressure on dollar peggers.

For me, that was a pretty important point. Note what Deutsche was saying. Had the Fed hiked, they might well have triggered a sell-off across asset classes, leaving managers with nowhere to run except the dollar. But if the dollar soared, it would magnify many of the ill effects brought about by the rate hike. I'm reminded of the following chart from Citi's Matt King:

(Chart: Citi)

So here's the question: given the increasing frequency of negative "shocks" and considering rising correlations and the bubble in bonds, where would investors turn to mitigate a large drawdown? Spoiler alert: there are no good answers.

I've talked quite a bit about the frequency with which tail events are occurring. But rather than look at 6+ standard deviation events, let's look at the occurrence of 2 and 3 std. dev. moves. Here's Goldman:

Measuring how frequent extreme asset price moves have been in the past, Exhibit 8 shows the average number of days over the prior 12 months with return moves (positive or negative) of 3 standard deviations or more for equities (we include S&P 500, FTSE All Share, DAX and TOPIX), using rolling 1-year standard deviations. Since 1986, no period besides 2008-09 has had a larger number of extreme equity price moves than we have experienced recently. As Exhibit 9 shows, there are generally more negative than positive 3-standard deviation moves for equities, indicating a negative 'skew' for equity returns. And recently the balance has shifted further towards negative moves.

Click to enlarge

(Charts: Goldman)

So how can you hedge? Well, that's the bad news. You can't.

Goldman goes on to note that although "there are two types of assets that help in diversification ('safe havens' that hold their value or gain during adverse market conditions, benefiting from inflows and 'hedges', which are negatively correlated with equities, in particular during drawdowns), since the mid-1950s, few assets had either characteristic consistently."

One hedge that has held up (i.e. maintained a consistent negative correlation with stocks during equity market drawdowns) since the 90s is safe haven debt. Have a look:

Click to enlarge

(Charts: Goldman)

But here's the problem: central bank largesse has made bonds less effective as a hedge (i.e. they're overbought) and on top of that, between CBs sucking all of the high-quality collateral out of the system and HFTs running amok, the chances of abrupt turmoil (e.g. VaR shocks) have increased dramatically. Here's Goldman again:

Bonds have become less effective hedges for 'growth shocks' at current low yield levels and rising inflation. Performance of a standard 60/40 portfolio has been more mixed recently fueling concerns about their ability to 'hedge' larger equity drawdowns at current levels of bond yields and with inflation picking up. During the S&P 500 drawdowns in August 2015 and at the beginning of 2016, bonds provided a less effective hedge with monthly returns of a standard 60/40 portfolio dipping to -5%, much larger drawdowns than during the Euro-area crisis and the global 'growth scare' in October 2014. In addition bonds are increasingly a source of risk as both the 'taper tantrum' and 'bund tantrum' showed. As a result investors are looking for alternatives to diversify equity risk, but in the traditional asset classes there might be few places to 'hide'.

(Chart: Goldman)

Okay, got it. So what about commodities? Well, as you can imagine, that's not going to work out either for rather obvious reasons:

More recently there have been little diversification benefits from investing in commodities due to a once in a decade shift in the commodity supply cycle and a comparably weak global recovery. In fact commodities have, similar to bonds, been a significant source of risk and volatility, in particular oil as correlations with equities have been firmly positive during recent S&P 500 drawdowns (Exhibit 28) - and at the beginning of 2016, the correlations were at similar levels as during the GFC.

(Chart: Goldman)

Note that this is indicative of the same polarization principle delineated by Citi earlier this year. Increasing homogeneity and interconnection creates inelastic markets, setting the stage for abrupt, exaggerated moves.

The presence of HFTs amplifies this phenomenon as all the vacuum tubes chase the same headlines. Throw in the risk from systematic strategies like risk parity and vol targeting and then top it all off with a lack of market depth and you've got yourself a really "interesting" set up.

More on this to come. In the meantime, find yourself a hedge.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.