E Flattening Yield Problem & Death By Low Volatility

This is the 'Fed Paradox'. By hiking rates simply to have ammo for when the next recession does arrive, they will end up causing that very recession themselves. This would be from the excessive tightening while the economy is already anemic and in decline.

At least, this is what the bond market is telling us. . .

Looking further, Bank of America & Merrill Lynch's client inflow/outflow supports this thesis that investors are expecting deflation. Thus the rotation out of "growth" related and into "bonds".

But another troubling thing caught my eye . . .

 

 

... it's the substantial inflows into the "low volatility" investments.

If there is anything we should have learned from 2008, it was the old teachings from Hyman Minsky (he has been deceased since 1996).

Minsky had taught that years of prosperity and extended periods of low volatility are what breed excessive risk-taking and speculation. Thus prolonged low volatility today sets the foundation for extreme volatility in the future.

Or otherwise said, when you feel safest and most confident things won't change, you undertake more risk because you feel secure.

And today the market has the volatility index (VIX) at multi-year lows. . .

 

Bank of America's strategist Michael Hartnett recently touched on this. He said:

"Central banks, the reason behind high asset prices and lowVol, are now in desperate dilemma: politically unacceptable for bubble on Wall St, but central banks will be tightening into deflation; inflection point for volatility is upon us and we recommend investors buy volatility. . . Fed tightening in 2017 could easily be followed by easing in 2018, in our view."

I couldn't agree more. . .

And with the crowd piling into 'lowVol' investments, this means discounts for the contrarian brave enough to buy 'highVol' investments.

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I look for investments that have the positive asymmetry (see-saw analogy) and that give favorable optionality. I use tail-hedging when the opportunity arises I normally use Long dated options for ...

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Moon Kil Woong 2 years ago Contributor's comment

The issue is that many run ups in the past were driven by excessive risk taking whereas this market run up is more a case of putting money in one of the few last asset classes that make decent returns more than a desire to take on risk. Because of this the move has been longer and more sustained and the risk has stayed hidden far too long.

It takes a trigger event to unwind it. For now, an obvious and predictable trigger has not presented itself. We will see if one appears on the near term horizon the next 12 months.

Lorimer Wilson 2 years ago Contributor's comment

Adem makes reference to Hyman Minsky who "taught that years of prosperity and extended periods of low volatility are what breed excessive risk-taking and speculation. Thus prolonged low volatility today sets the foundation for extreme volatility in the future. Or, otherwise said, when you feel safest and most confident things won't change, you undertake more risk because you feel secure."

You might be very interested in Minsky's 5 Stages of a Bubble - Where Are We Now? (www.munknee.com/minskys-5-stages-of-a-bubble-where-are-we-now/) which identifies the 5 stages and concludes that "How much longer and higher stocks and bonds may run in the Everything Bubble, no one can predict, but for those who stay invested in inflated assets, be aware that you are implicitly increasing your risk tolerance well beyond levels which typical risk-averse investors would be comfortable with."

What stage do you think we are in - Boom, Euphoria or Profit-Taking and why?