Interpreting the Market’s “Chronic Quietness” and What May Lie Ahead
Dr. Ashwin Alankar sits down with Tom Keene on Bloomberg Radio for a wide-ranging interview discussing what the options market is signaling for equities, inflation and the revolutionary impact from technology.
- We see low volatility, or the market’s chronic quietness, as one of the biggest distortions caused by ultra-accommodative monetary policy and expect it to normalize as rates rise.
- Our option-implied signals indicate that the economy is solid and we see no signs of a pending drop in economic activity.
- However, under the hood, the options market is starting to indicate an end to recent trends with value potentially catching up to growth and small-caps catching up to large-caps.
- We believe that investors should be more concerned about missing out on the upside than protecting against drawdowns at this time and that inflation will likely remain muted.
Ash Alankar is with Janus Henderson and he joins now on the derivative space and the equity space as well. Ash, it’s so quiet out there, with the VIX at 9.60. How have your studies changed with the chronic quiet that is out there?
Good morning, guys. Excellent question. I do believe and we do believe that this chronic quietness, this calmness, this pressure to the downside of the VIX is one of the biggest distortions created by accommodative and assimilated central bank policy over the last six, seven, eight years. The reason being is, if one can’t get carry, one can’t earn income the traditional way, where that traditional way is holding bonds, people look for alternative ways to earn carry. And a lot of people talk about volatility as an asset class, and it is an asset class where the purpose of volatility in many people’s mind is to short volatility to earn carry. So as people have shifted away from the traditional way of earning income, they have looked at ways of earning income by selling volatility, which is why the VIX is so low, in our opinion; and why the MOVE index, which tracks the volatility of interest rates, is so low. But ultimately as rates rise, people move back to the bread and butter. They’ll go back to the old fashioned way of earning income and this distortion caused by low, low rates, which has translated to low, low volatility, will normalize. So normalization will not only bring rates to a more reasonable level, but they’ll also bring volatility to a more reasonable level.
What do you get when you look at the options mark now? What’s it telling you about the health of the U.S. economy and about the markets as well?
The option markets are telling us the health of the U.S. economy is quite solid. We are not seeing any signs, of a pending shortfall or a pending short drop in economic activity. Rather, we’re seeing steady as you go and I think that that’s a function of what you see on the macro prints. ISM numbers are reaching all-time highs. Labor markets are very, very strong. The one uncanny thing is inflation and inflation is on everybody’s mind.
How about, what’s it telling us about equities in particular? That’s the sense of the macro economy. How about the equities market?
Equity markets look, at the top level, equity markets are actually showing a very good ratio of potential upside versus potential downside. So when we look at that ratio, think about that as a tail-based Sharpe ratio and it’s a barometer of attractiveness, it looks quite good. But under the hood we actually see something quite interesting. Some of these trends which have characterized the bull market over the last few years, they could be bottoming, so two such trends are growth versus value. Growth over the past several years has really outperformed value. The second trend is large cap versus small cap. Large cap has really outperformed small cap as well. The option market is starting to send us some signals that, hey, small cap might be catching up to large cap. Value might be turning around to catch up to growth. So whereas at the surface everything looks calm, there are some ripple effects underneath them that one should pay attention to.
Let’s come back. Ash Alankar with Janus Henderson, much to talk about. Joining us now with Janus Henderson, so there is a great leverage Ash, that you live in every day. I want to talk about translating what we spend a lot of time on. Can we be stable or do we worry about instability and gamma? I’m looking at gamma as a second derivative, the acceleration when things fall apart. Where is gamma now?
Gamma is exactly that acceleration and we see more gamma to the upside. So it’s our strong belief that the risk and the fear that investors should pay attention to is not a meltdown, but a melt-up. So remember with investing, the two biggest forms of risk when it comes to your financial portfolio is the obvious risk of losing a lot of money, but it’s also the less obvious risk, which became quite obvious in 2013, which is the risk of failing to participate in that large upside. So if you ask me what risks are more dominant today and are being priced with, I wouldn’t say aggressiveness, but being priced by the options market, it’s more the risk of markets rising and investors failing to participate in that rise in the market.
Ash, the last time you were on, after the last time you were on, you wrote me a quick note and said the next time you wanted to talk about the fallacy of averages, about the bell curve and the dangers of using the bell curve, and you painted a very vivid picture here of one Tom Keene trying to cross a river, and you and me assuring him that on average it’s three feet deep. Tell us a bit about why it’s so dangerous to rely on the bell curve now.
The reason why it’s so dangerous to rely on averages is when it comes to your financial portfolio, you only get one path of time. If you lose 50%, you don’t get another opportunity to replay that period. You’ve suffered a permanent loss on your portfolio. So averages are rooted in the belief that you can repeat the game. You can play the game over and over, and over again, such as if you’re playing blackjack and the cards are in your favor. So on average, your payout is going to be 51 cents and your loss is going to be 49 cents. If you can repeat the game over and over, and over, ultimately, you’ll leave with an extra penny. But when it comes to investing, you don’t have that luxury of repeating the game, which is why if you look to see historically what’s explained, the risk premium of any asset class, it’s not the average risk premium, rather it’s the outliers. It’s the large losses, which is why it’s so dangerous to model the markets as a normal distribution, why it’s so dangerous to model risk as volatility, and why it’s also so dangerous to use expected returns as a metric of upside. The average is just noise and noise is unpredictable. Noise doesn’t leave a permanent footprint on your portfolio. And so that’s why it’s so dangerous.
What was it like to co-write with Myron Scholes of Black-Scholes, and of course, the Nobel laureate? What was it like, the honor of having him correct your grammar and use of Greek letters?
Correct my use of Greek letters, it was great. I mean, Myron is one of the stalwarts, arguably one of the most famous modern financial economists, the father, I would say, of modern finance, the father of derivatives. You learn a lot from him. He’s not just an academic. What’s unique about Myron is he’s not just a unique, he’s not just an academic. He’s a practitioner. He understands the frictions between what you learn in the classroom and what’s in practice.
What’s great about it, he’s got a great humility because he’s enjoyed losing money before, which is certainly something that brings humility into it as well. What are you worried about right now, Ash? I mean, within the mathematics and the reality of Dow at 23,000, what keeps you up at night?
Honestly, right now, not too much. The one thing that I do fear and it keeps me up a little at night is an unexpected shock to inflation to the upside, because should that happen, the Fed would have to move quite aggressively. But to be honest, we don’t see that happening. We don’t see inflation shooting to the upside. We actually do even believe this 2% target that central banks peg themselves to is a relevant target. If you go all the way back to a neo-Keynesian growth model, so the esteemed and brilliant Solow model, Robert Solow, back in the ’50s, he said, well economic growth, there’s actually three inputs to the economic growth. It’s the typical labor input, capital input, but also technology. And technology can be a catalyst for great economic growth, and technology also then is a catalyst, which puts a lid on inflation because technology brings productivity to the system. So maybe we are entering a new structural regime led by technology. And what is that technology? Well I would argue the first major breakthrough in technology was the printing press. The printing press now brought information to everybody. No longer were books stored in monasteries. Information and knowledge was shared with everybody. (In the U.S.) That was back in the late 1800s. And today, what is the revolution in technology?
The radio microphone.
It’s not the dissemination of information. It’s actually intelligence. It’s the processing of information via artificial intelligence, via big data, via business analytics. So now, information is being processed more efficiently. So if the printing press had a huge impact on the productivity of the U.S., the productivity of the world, which was dissemination of information, imagine now that we’re better at processing information. We’re getting external intelligence. That has to have a lasting impact, and I believe that lasting impact is going to showcase itself by muted inflation.
Ash, thank you so much. Ash Alankar with Janus Henderson.
Loving having him on. A huge response when he’s on because it actually almost comes out in English.