Who said zombies and finance can’t mix? A recent piece by David P. Goldman in the Asia Times reflected on the recent behavior of the U.S. economy and its future, ultimately concluding that we’re in for a whole lot of nothing on the future. The economy, by his measure, is currently the walking dead. As he puts it:
“The so-called American economic recovery won’t die, because it’s undead. It was a zombie to begin with. Equity investors during the past six weeks came to the collective conclusion that the US is not in the early phase of an economic recovery, but in the endless middle of a structural slump, in the term of Nobel Prize winner Edmund Phelps.”
He includes an interesting graph on realized volatility, showing that the recent sell off from the May highs is not the type of negative return/higher volatility data point we would expect, showing a loss of about -5% with associated volatility of about 13.5 – versus the previous eight -5% periods having a realized volatility of between 23 and 33, or about 2.2 times as high. Indeed, the recent stock market loss has the lowest volatility of any such loss over the past four years.
Mr. Goldman’s conclusion as we read it is that we are in for more of the same, due to the artificially low interest rates where banks happy to borrow at zero and loan back to the Fed at slightly above zero (a risk free trade), and the fear of companies to spend on building up inventory.
And here’s where it gets interesting in regards to managed futures. Such a slow grind lower would likely not be in the best interest of managed futures, who are ‘long volatility’ type programs which look for breakouts to new levels; as a slow grind lower would likely include many false breakouts via returns to the mean, and no substantial moves away from the mean (all within the context of a downward trend we would expect managed futures to participate in).
Managed futures losing money during an extended stock market decline is a growing, yet unspoken (up to this point), worry in the managed futures industry, with the logic that 1. We only have a small data set of crisis periods to base managed futures performance on looking backwards, and 2. Managed futures and stocks are non correlated (not negatively correlated).
For an industry which has built its reputation on ‘crisis period’ performance (outperforming stocks during down markets), not delivering would be a big problem.
So is Mr. Goldman correct? Are we in for a ‘new normal’ where volatility declines alongside the stock market.
We’re not so sure. One, such calls for a ‘new normal’ where earnings and volatility are low are usually met with the exact opposite transgressing. And indeed, we saw a spike up in the VIX last week just as we were contemplating writing this piece (whenever you want something to happen in the markets – just start planning a newsletter or blog post on the opposite of that happening, and voila – you get your result)
Two, history is ripe with examples of low volatility periods ending with spikes higher in volatility, and indeed it is often used as a contrary indicator for upcoming market declines.
Three – one data point does not make a conclusion.
Four – it may not matter for managed futures whether he is correct or not, as long as there is expanding volatility elsewhere. There could be low stock market volatility coupled with a declining stock market – but high volatility elsewhere in bonds, currencies, energies, etc. which fuel managed futures returns. Managed futures non correlation with stock markets does not come from just its ability to go short stock indices, but also its involvement in myriad other markets and (hopefully) trends.
We’ll see what the future holds for Zombinomics and managed futures.