Market volatility has returned with a vengeance over the past two weeks. It’s a bit scary after such a long period of market tranquility, but if we can keep our heads about us, there is a lot to be learned from what looks like a technical correction in stocks.
Like many other market pundits, I attribute the market’s mood change primarily to recent steep rises in interest rates. It's important to understand how what is being perceived as a general and perhaps permanent rise in interest rates affects the valuation models many professional and institutional investors apply to corporate profits.
When analyzing a corporation’s profits to evaluate what an investor considers to be a fair valuation for the company’s stock, interest rate assumptions are used as a sort of discount factor. Lower interest rates make each dollar of corporate earnings “worth more” in terms of a future valuation model, and so as interest rates look to be permanently rising, many institutional investors are busy adjusting their assumptions and their portfolios for this change.
This makes some selling normal at times when expectations for interest rates are changing, like they are right now. But that’s not the entire story.
The long period of generally rising stock prices and historically low volatility in stock prices also had other effects. At times when an asset class behaves in an unusual or unidirectional manner for an extended period, speculators are likely to devise strategies to exploit the situation.
In 1999-2001, the speculation occurred with dot.com stocks, which had defied gravity over a period of years. These speculators included a wide swath of retail investors, who at the time adopted dangerous and aggressive margin trading strategies. Margin involves borrowing money to buy stocks. In up markets margin trading has the ability to enhance gains, in down markets it can be a disaster as investors risk losing more capital than is actually in their accounts. The 1999-2001 period ended badly for many retail investors as the dot.com bubble burst, wiping them out. Lesson learned.
In 2008-2009 the speculation was occurring in two different areas related to residential real estate. First, many “investors” and home owners in red hot real estate markets were buying houses with no money down, confident prices would continue rising. When the trend reversed, and prices collapsed, they abandoned the properties, shifting the losses onto the institutions that had lent them the money.
In addition, the institutions themselves had engineered a whole plethora of complex financial products which also involved borrowed money, or leverage, and as home prices collapsed the whole system became unstable causing the 2008 financial crisis.
In both previous periods of speculation, the aggressive and leveraged speculative behavior had boiled over widely into the general population, first with margin trading by retail investors and later with dangerous mortgage loans.
What about the past few weeks? Do I see this type of development this time around? I do, but this time the trend is related to the lack of market volatility itself. The long period of smooth markets spawned speculation in betting on volatility itself as once again speculators developed complex, aggressive, and yes, leveraged strategies to profit from this trend.
When market volatility returned with a vengeance, many of these products and strategies unwound very quickly, causing even more volatility as these speculators got once again wiped out. This process remains ongoing.
The good news is the current “short-vol” speculative trend is much less widespread, and so as it corrects itself is much less likely to lead to contagion. Unfortunately, as long term investors, we will have to continue to endure the unwinding of complex speculative behavior from time to time. This time, however, I have a hard time seeing how this boil-over material has staying power.