The Anatomy Of Market Risk

Sep. 18, 2017 11:52 AM ETTVIXF, UVXY, XIV
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Douglas Adams
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Summary

  • Market reaction to the provocations emanating from the Korean Peninsula have remained curiously quiescent given the proximity of Seoul to the world's most heavily fortified frontier.
  • Political and risks of nature are largely treated by equity analysts and central bankers alike as transitory events with few secular impacts to overall economic activity.
  • There are few predictive algorithms being written written for equity market consumption on political and natural risks and disaster modelers have little demand for their research in broader market contexts.
  • Short positions on the VIX and the VXN have become wildly popular and financially lucrative as investors play the more predictable leeward side of market disruptions.

While the crisis on the Korean peninsula continues to twist and turn week by week, market indices have, for the most part, remained curiously quiescent toward the untoward displays of saber rattling. The traditional safe harbor vehicles have registered few outsized inflows of capital. The most notable market move was the rally in Treasuries have came within striking distance of pre-election levels through the week ending 8 Sept, sending the yield on the 10-year Treasury note to a year-to-date (YTD) low of 2.054%. Bond prices moderated last week as the yield on the 10-year Treasury note rebounded to 2.203% at Friday's closing bell (15 Sept). While the tensions on the Korean Peninsula continue to swirl in the background, the rally arguably had more to do with economic considerations: the stark dichotomy between the yield on comparable bunds, gilts and Japanese government bonds, entrenched inflation and the probability of a December hike in the federal funds rate than the latest test launch of a North Korean ballistic missile or detonation of a nuclear or even a thermonuclear device. Gold hit a year-to-date high in the previous week only to fall back last week with its fate tied more to the broad weakness of the dollar in world currency markets, the lack of inflation in the greater economy and lower expectations of further increases in the federal funds rate than to the events on the Korean peninsula. Emerging market indices have begun to trail off somewhat since August, but these are more likely anticipatory hedges by institutional and retail investors alike ahead of September's Federal Reserve meeting which is expected to provide more clarity on the path of the federal funds rate through the end of the year, not to mention the FOMC's desire to begin the process of reducing its $4.5 trillion balance sheet. None of these market moves unequivocally tie to the unfolding events in North Korea. Even the Kospi, the main South Korean stock exchange, is up just over 16% on the year, according to Bloomberg data. It goes without mention that Seoul metropolitan area is home to almost half of the country's 51 million people and is less than 35 miles from by far the world's most heavily fortified frontier. The quixotic response to such a fundamental risk appears at first glance curious.

Figure 1: CBOE Volatility Index ($VIX) and the Nasdaq Volatility Index ($VXN) since 2001

https://stockcharts.com/c-sc/sc?s=%24VIX&p=M&st=2001-01-01&en=today&i=t06161528240&r=1505049261312

Market movements to risk come in four broadly defined flavors: Political, natural, market and systemic. Market moves to risk of whatever flavor are invariably reactive rather than proactive responses almost by definition. Warning time is often short and defensive mechanisms difficult to employ. There are few predictive algorithms being written to track risk for equity market consumption and disaster modelers most times have little demand for their research outside of specialty insurance markets or within short spans of time immediately after the event itself. Long positions on the VIX, such as Velocity Shares VIX (TVIX), ProShares Ultra VIX (UVXY) or long option plays amount to almost hopeless attempts at keeping one step ahead of market direction-without the supporting hard data inferences as to which direction the market is actually headed. The VIX has been in contango for about 70% of the trading days back to 2005. Long VIX ETNs literally sketch out images of death incarnate by buying ever more expensive future contracts and selling out ever cheaper contracts that are about to expire-all on the hope that some downside market event will place the bet in the money.

On the short side of the equation, the picture is quite different. Positions like Velocity Shares Inverse VIX (XIV) reverse this Sisyphean dilemma by selling expensive longer-term VIX futures and waiting for the contracts to expire at a much lower price and pocketing the difference. While the ETN does employ a kill mechanism that can be triggered if losses exceed a certain level in any given trading day of 80%, by the very nature of the market strategy being employed-shorting the VIX has been one of the most lucrative trades going. The return has been almost 837% since its launch on 30 November 2010. By way of comparison, the return on the S&P 500 since its 9th of March 2009 trough is just under 270% through Friday's market close (15 Sept).

Political and natural risks are largely treated by most equity analysts and central bankers as transitory events and, for the most part, are confined well within a single standard deviation around the prevailing market mean. Earthquakes and our most recent experience with the hurricanes that pummeled Texas and Florida, just as Hurricanes Charley (2004), Wilma (2005) and Katrina (2005) before them, trigger a localized fiscal stimulus and multiplier effect as a result of government, insurance and consumer spending attached to the rebuilding effort. In most instances, the stimulus is more than likely to offset the downside on the destruction itself. Jobless claims in the affected areas invariably experience sharp upticks. Similarly, inflation data surges as prices from gasoline to staples to construction materials and generators to insurance adjusters rise on the back of shortages or availability issues created by outsized demand and disrupted supply chains. These distortions often impact economic data for several months, perhaps a quarter. Invariably, these events have little impact on monetary policy and only marginally impact overall GDP growth-and then largely contained to the subsequent quarter.

Market and systemic risks are a rather different sort of animal. After all, in a service-oriented economy consumer spending drives corporate earnings which in turn drives overall economic growth. Accordingly, market analysts spend an inordinate amount of time and energy attempting to understand and predict market direction-all with varying degrees of success. Bouts of market risk take much longer to squeeze out of the economy than with one-off events typical of risks associated with political and natural causation. Systemic risk takes even longer before underlying economic indicators resume a more established and predictable trendlines - a process measured in a year or more. Monetary policy is likely triggered and GDP growth is impacted over the course of quarters that could stretch into years. While one-off natural disasters invariably trigger back-end fiscal stimulus in the rebuilding stage, political events may or may not trigger such stimulative spending. Political risks may trigger large outlays of one-way capital expenditures directed abroad, such as the conduct of the Iraq and Afghanistan wars or the war on terrorism in the aftermath of the World Trade Center attack, with only peripheral expenditures sourced through domestic sources.

Figure 2: The VIX on 9 September 2001 through the Iraq War (March-May 2003)

http://stockcharts.com/c-sc/sc?s=%24VIX&p=D&st=2001-08-01&en=2003-12-31&i=p20762585959&a=544116452&r=1505248993793&r=1505249321008

A long list of destabilizing political events since the turn of the 21st century provides but a handful of pronounced spikes in the CBOE VIX ($VIX), mirrored closely by the Nasdaq Volatility Index ($VNX) (see Figure 2, above). The terrorist attack on the World Trade Center on 11 September 2001 pushed the VIX to a record reading at the time of 43.74 by the market close on the 20th of September, a little over a week after the event. The VIX spike in reaction to the World Trade Center attack was well above both the 25.75 average reading for the year and the overall average reading of 19 on data back to January 1990. The World Trade Center attack was close to a tail or "black swan" political risk given the sharp surge in the VIX within a week of the event. The event's impact on market behavior rather quickly morphed into a market risk event with the cumulative impact of two of the most defining bankruptcy filings of the period which prepared the way for the market crash of market crash of July-August of 2002. It would take six months for the VIX to return to pre-September (see Figure 2, above).

The Enron bankruptcy filing in December of 2001 put a stop to a sliding VIX in the wake of the market reaction to the terrorist attack on the World Trade Center in September of that year. While grabbing the distinction of being the biggest US corporate bankruptcy in US history at over $60 billion, the risk level to the one-off market event measured by the VIX remained surprisingly muted. From the 20th of September and a reading of 43.74, the VIX had fallen to a reading of 25.73 Enron Chapter 11 filing on the 2nd of December. Of course, it was only a short seven months later when Worldcom would assume that mantle by filing its own Chapter 11 paperwork with assets of over $100 billion. The VIX had bottomed out on the 23rd of May at a reading of 18.23, below its historical average at the time of about 20 before spiking to a reading of 29 the day of the filing on the 2nd of July. By the 23rd of July, the S&P 500 was down just under 33% YTD. The VIX would spike to a reading of 45.08 by the 5th of August, exceeding its post in the belated response to the World Trade Center attack as the events of the past seven months culminated with the market crash of July-August 2002 (see Figure 2, above). It would take a full 13 months to squeeze the accumulated market anxiety out of the system.

From a market perspective, the Iraq War in March of 2003 was a one-off political event. The VIX spike to a reading of 33.61 on the 11th of March, almost two weeks before US boots were on the ground in Kuwait. By the time coalition forces reached the gates of Baghdad, the VIX was only slightly in front of the average reading for the year of 22. Market volatility had largely disappeared in surprisingly short order. From April 2004 through the end of 2007, the average VIX reading for the period came to 14.52-well below the overall average reading of 19 on data back to January 1990 (see Figure 2, above).

Figure 3: The Great Recession 2007

https://stockcharts.com/c-sc/sc?s=%24VIX&p=D&st=2007-12-31&en=2009-07-31&i=t62725344046&a=544116452&r=1505261602224&r=1505261764911

In the early spring of 2008 three hedge funds tied to tranches of Alt-A mortgage backed securities (MBS) would eventually undermine the ability of 84-year old Bear Stearns to meet its credit obligations. This was after the company put up six consecutive years of earnings through the end of 2006 as the company skillfully rode the crest of the housing boom to its peak in April of the same year. By the 4th quarter 2007, the company had posted its first ever loss. By the end of March 2008, bleeding cash, Bear Sterns was hastily sold to JPMorgan Chase with the Federal Reserve Bank of New York providing financing for the deal. JPMorgan Chase paid $2/share for a company that had a stock price of over $170/share in January 2007. The VIX had hit a reading of 32.24 by the 17th of March-its highest post since the Iraq in March-May of 2003.

Of course, it was the demise of Lehman Brothers in September of the same year that provided the drive to send the VIX to his highest post ever, hitting a reading of 80.06 by the 27th of October. Within days, the Federal Reserve Bank of New York loaned AIG a whopping $85 billion, taking 79% of the company. The intended purpose of the Fed's unprecedented foray into the private sector was to stave off default with a web of counterparty credit obligations centered on the sale of credit default swaps backing corporate and particularly US mortgage debt that was compromised by housing prices that nationally had already fallen by 24% by October 2008. Housing prices in Phoenix had fallen even further-an eye-popping 42% since peaking in May of 2006. Miami followed closely dropping over 38% since June of 2006. US GDP growth would contract for four consecutive quarters from the 3rd quarter 2008 through the 2nd quarter 2009 before returning positive with a gain of 1.3% in the 3rd quarter of 2009. It would take over seven years before the VIX got close to the reading it posted in the latter days of January 2007. This is our first real example of systemic risk in the tenure of the VIX as a market measure. The Great Recession of 2007 was also the biggest market event since the Great Depression.

Figure 4: VIX and VXN since 2010

https://stockcharts.com/c-sc/sc?s=%24VIX&p=D&st=2010-01-01&en=today&i=p63830589543&a=544369653&r=1505474916662&r=1505476171169&r=1505477453871&r=1505480601050&r=1505480766302&r=1505481058565&r=1505482932515&r=1505483288757

Market risk continued apace at the start of 2010 with debt worries in the peripheral states of the euro-zone breaking out anew with the bailout of Greece in April 2010 and no pan-European mechanism to deal with acute cases of sovereign debt (see Figure 4, above). The EU cobbled together government-to-government loans and guarantees to see the Greek economy through its first of three bailouts which would eventually see the Greek economy shed 25% of its former economic capacity amidst conditions not seen since the US depression in the 1930s. The EU scrambled to set up just such a pan-European mechanism to deal with both the growing debt crisis and to calm the growing chorus of sell orders in international markets. The European Financial Stability Facility (EFSF) was a temporary fix to the problem and came into being in June 2010. (The European Stability Mechanism (ESM), the EU permanent bailout facility, would not come on line until September 2012, with its projected funding mandate of $500 billion not going live until 2025.) The creation of the EFSF failed to stave off a European stock sell-off in the summer of 2011 as Spanish and Italian sovereign debt levels vastly exceeded EFSF liquidity on hand, sending stocks plummeting worldwide. It would take another 12 months and a speech by ECB president, Mario Draghi "…to do whatever it takes…" in July 2012 to end the run on European stocks and its currency. The run was codified by the September 2012 placement of the Outright Monetary Transactions (OMT) facility which would finally offer a qualified backstop to financially besieged EU member states in exchange for the implementation of a fiscal recovery program supervised by the EU, the ECB and the IMF. The show of force successfully calmed European equity and debt markets. To this day, after numerous challenges questioning the legality of directly funding member governments by the ECB under the Maastricht Treaty (1992), OMT finally acquired legal standing. The facility has never been called upon by a EU member state. Along the way, a one-off tail-event in the guise of an earthquake and resulting tsunami at the Fukushima Daiichi nuclear power plant that would eventually shut down 41 of Japan's 43 nuclear reactors the previous March (see Figure 4, above).

The largely unexpected devaluation of the renminbi in the waning days of summer 2015 sent a frigid blast of Arctic winter through bond and equity markets for the next six months. The offshore renminbi went from $6.20 to $6.40/dollar overnight with little warning. The Rmb/USD exchange rate is controlled with daily moves limited to within 2% of a central fixing rate set by the Peoples' Bank of China (PBOC), China's equivalent to the Federal Reserve. The 1.9% currency move was the largest one-day devaluation since 1993. The cumulative depreciation over 11-12 August was 2.8%. By contrast, Brazil's and Russia's currencies depreciated by 35% and 45% versus the US dollar over the past year though the end of August 2015. The difference was made up by the PBOC spending hundreds of billions of dollars of foreign exchange reserves in support of its fledgling currency. The cumulative impact on US equities produced the worst January performance in more than a century (see Figure 4, above).

Markets are fickle in regard to political risk and are likely ill-equipped to properly assess the market meaning of such events prior to the events itself. Markets failed to foresee the economic dimensions of Brexit, the election of Donald Trump, the market consequences of keeping national sovereignty firmly in place at the launch of the euro and countless other political events throughout recent history that impacted market performance worldwide. Investors have also learned that political events, save those outsized, black swan events, are almost universally short-lived in their impact on markets.

Natural risks, while generally localized, invariably come with a fiscal stimulus package on the back-end rebuilding phase that often offsets the cost of the damage itself on the front-end of the event. These events as well prove to be relatively short-term in nature.

Market and systemic risk are always more impactful on markets and the difference here is the duration of time and triggering of monetary policy to affect market stabilization. Examples of market risk are replete in the relative short life of the VIX and the lesser known VXN measures. Systemic risk is, fortunately, a much more rarely occurring event. The Great Recession of 2007 presents a textbook example of systemic risk, the effects from which the US economy continues to recover.

North Korea, a country whose estimated GDP output is about half of the $62 billion annual market for pet care here in the US, is not taken seriously by western markets. About 90% of its exports are now under international embargo, but about 83% of those exports go to China, which supplies about 85% of the country's imports and most of its oil. For years, North Korea has been forced into developing a web of black-market suppliers, which includes oil shipments from Russia through Singapore middlemen, according to news reports. There is likely no country on earth that is better versed in tapping such shadow markets, nor one capable of enduring material derivation than Pyongyang. After all, the country lost an estimated 2 million of its own people to famine that ravaged the country in the 1990s. Vladimir Putin was recently quoted by news media sources that North Korea would rather eat grass than to give up their nuclear program.

The limited market reaction to date is for most western observers an appropriate response to outbursts that are far beyond the pale of what most consider civilized thought. Until something actually happens to change investors' behavior, the insouciance toward Pyongyang will likely continue. Of note, however, is Seoul's response to Tuesday's (12 Sept) ballistic missile overfly of northern Japan. Within ten minutes of the launch, Seoul fired a short-range ballistic missile off of its east coast, simulating an attack on the North's weapon facilities. A tougher approach to the rogue nation could be in the offing. The path forward remains unknown.

Assured massive destruction is the ultimate deterrence that has kept the relative peace between nuclear powers since the weaponization of the atom in the closing days of WWII. A more credible guarantee of the peace still awaits the light of day.

This article was written by

Douglas Adams profile picture
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Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.
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Disclosure: I am/we are long XIV. 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.

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