Fund manager view: “The biggest fear is fear itself”

8th March 2016

Rowan Dartington Signature’s Guy Stephens takes a closer look at market volatility and whether or not it can be profitable…

A month ago today the markets were in crisis mode. Volatility, as measured by the VIX Index was around 26%, the highest reading since the Chinese slowdown scare of last August. The FTSE-100 Index was plunging, reaching its nadir of 5,500 in the morning of 11th February. Since then, the EU Referendum has kicked off further adding to uncertainty but the FTSE-100 is now 12% higher at the time of writing. How does this make sense and what do we make of it?

The first catalyst has been the recovery in the oil price and this has removed much of the immediate focus on the sector and reduced global market tension. What has become very clear is that there was a significant degree of market manipulation taking place and we have heard reports that over 80% of the transactional activity influencing the oil price was paper-based rather than driven by actual oil users.

This is the nature of the investment markets that we live in today but what is important is to recognise when it is going on and not get caught up in the panic. Remaining cool headed and able to exploit the inevitable volatility this creates can be very profitable.

The wider equity markets are increasingly manipulated by similar forces of speculation with computer based trading activity responsible for over half of normal daily volumes in today’s equity markets. This shows itself at these more extreme moments and instils a sense of hysteria that the markets know something that the investor doesn’t.

Rationality only returns when a few heavy weight commentators and investors start being quoted with a similar view that everything has got a little out of hand and we all need to calm down. This is exactly what happened following the Deutsche Bank panic and the view that a re-run of the credit crunch was approaching.

However, more recently, Mervyn King has come out of his retirement from Governor of the Bank of England and declared that there are similar strains within the global system, but this has been rather diluted as he is currently promoting a book.

There is a structural reason as to why we see more extremes of volatility and this lies in the markets pre-occupation with volatility itself. The FCA and many money-managers define volatility as risk which is partially true but is a very one-dimensional observation. There are many different measures and causes of volatility and also many different measures and causes of risk. For example, volatility was low and had been low throughout all of 2006 and for half of 2007. It then became elevated to similar levels as seen recently to between 20-30% for the next year as the sub-prime mortgage problem in the US emerged but with no hint that the credit crisis lay ahead. This is where its use as a measurement of risk leaves much to be desired. It is a backward looking indicator and tells us what has been happening and makes the assumption that we should therefore be worried.

In fact, the time to be worried was before the volatility arrived. When volatility rises, risk-appetite falls and investors sell. This means that reactive computer driven algorithms also sell when volatility trigger points are breached and so on until a human being gets involved and breaks the circuit. This is partly why we have seen such lurches since the beginning of the year.

Returning to almost exactly a month ago, when volatility was elevated, this would have told us that risk had risen when in fact it hadn’t. What had changed was investor’s perception of the risk and that is a very different thing. With the VIX Index now back at 17%, has anything really changed that much from a month ago? This flawed thinking is built into the algorithms that drive the high frequency trading and this serves to increase market volatility. Indeed it was F D Roosevelt that said that the only thing we have to fear is fear itself. The VIX Volatility Index is often known as the ‘Fear Index’ and when this is applied to a portfolio managed by a computer based on volatility bandings, the investor buys high and sells low which is the wrong answer.

So, for now, volatility has returned to where it was at the end of 2015, but interestingly the equity market has not quite recouped all its losses. This is most likely lingering doubts from would-be investors who are still somewhat in a state of shock having forgotten what equity markets can do and how scary they can become. No doubt they will feel more comfortable when the market has recovered a little more, but in allowing the fear to take over they have missed a very attractive buying opportunity.

 

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