Ecoinometrics - A not so disorderly market

It feels like a lot is happening this year. But how volatile is this market really?

Sep 26

There are several ways to characterize market regimes.

Most of the time investors talk about being in a bull or a bear market. They do so as a way to talk about the big trend in value. Do things tend to go up or down?

But that's not the only way.

Another question you can ask about the market regime is: are we in an orderly or a disorderly market?

And the way you might go about gauging that is by looking at volatility.

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A not so disorderly market

Many of you who are investors in 2022 haven't experienced the full force of the Great Recession of 2008.

That includes myself.

What I remember of the Great Recession is that it was hard to find a job and as a result you had to tightened your belt.

On the investment side I did remember following the news about it pretty closely, but given that I had no money to invest the whole market meltdown felt a bit abstract.

So setting aside the couple of bear markets I've weathered as a Bitcoin hodler, the current situation is the closest experience I've had of a recession as an investor.

Now we aren't yet officially in a recession. But for sure most asset classes have already been hit relatively hard.

The Federal Reserve is doing its most aggressive rate hike sequence since the 1970s. And it is doing so from an extremely accommodative starting point, applying it to an economy addicted to debt.

Naturally that stings and assets are reacting to it accordingly.

Pick your favourite asset and see what it has been doing since the start of the year. Everything is on the move.

Risk assets? They have been hit by quantitative tightening. Bonds? They have been hit by the Fed hiking rates. Currencies? They have suffered from a strong dollar and random local monetary policies. All that in the name of dealing with the highest level of inflation since the 1970s.

Except for gold who isn’t doing much there is a single trade unfolding everywhere.

We all know how this is going to end. The Federal Reserve will stop when the main concern shifts from inflation to unemployment. So far the job market is robust which means the Fed will continue to tighten.

The reason they can do that is that while stocks and bonds are down, the markets haven’t turned into a complete mess. Nothing is completely broken. We haven't entered the disorderly phase of the meltdown.

Actually there is a way to quantify that. We can look at the realized volatility relative to the meltdowns that have happened over the past 20 years.

To visualize that we plot the distribution of realized volatility over the past 20 years for a bunch of assets. That means each point represents the realized volatility of an asset on a given day. You read the volatility on the horizontal axis, the further a point is on the right, the more volatile the period. On top of that we colour each point based on some interesting historical period it falls into (like the 2008 crisis or the COVID Crash). The current period (start of 2022 until now) is flagged in red.

This is how it looks like for the 60/40 portfolio.

We can kind of distinguish three different regimes of volatility:

Starting from the left you have the normal regime. This is the standard level of volatility for that asset, where the bulk of the points are.
Then moving further right where the distribution becomes more narrow you have the volatile but orderly regime. This is basically the kind of volatility that you see when there are big moves in the market. It happens often enough that this cannot be qualified as exceptional.
Finally you have the long tail of very high volatility to the right. Those are extreme events, what we call the disorderly regime. Think about market crash and liquidity crisis when you see this tail.

Now working in reverse from the tail back to the normal regime:

In the disorderly regime you find the extreme events that unfolded during the COVID Crash (in green) or the 2008 Financial Crisis (in green).
In the volatile orderly regime you find the seeds of both the COVID Crash and the 2008 Financial Crisis. Those extreme events of the tail do have warning signs.
In the normal regime you will find very little (or really at the right edge) points corresponding to crisis periods.

This year so far (in red) has stayed confined in the volatile orderly regime. The 60/40 portfolio is hurting but it is doing so in an orderly fashion.

That’s the difference between pricing in a change in macro economic conditions (volatile orderly) and breaking down (disorderly).

What about other markets? Where do they fit in this picture? Well, see for yourself.

Several things to observe on this chart:

Bonds and stocks have spent 2022 firmly in the volatile orderly regime.
Some currencies like the British Pound or the Yen (maybe gold) are starting to move in the volatile orderly regime even though they have spent a fair amount of time in the normal regime.
Interestingly cryptocurrencies haven’t spent much time in the volatile orderly regime. Maybe you can argue that Bitcoin has a wider normal range than your typical asset and that’s changing the calculus a little bit. But compare Bitcoin or Ethereum to Tesla and you’ll see that paradoxically those two haven’t been that volatile. By any measure they have not moved in the disorderly phase.

What can we conclude from that?

We can say that while most assets are reacting to the macro conditions turning more hostile, they are doing so in an orderly fashion. Assets are pricing in a change in monetary policy from the Federal Reserve in the same way that they reacted by skyrocketing after the Fed flooded the market with liquidity following the COVID crash.

That being said disorderly regimes always start with periods of volatile but orderly markets… until something breaks. Probably a sign that we are only one step away, one policy mistake away from a meltdown.

The worst is not guaranteed but I’ll take that as a sign of caution, we have not seen how bad this can get yet. Position your portfolio to survive a meltdown and get ready for potentially great buying opportunities.

That’s it for today. If you have learned something please like and share to help the newsletter grow.

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