The Alleged Evils of “Volatility”
Whenever there is talk in the popular press or in the mainstream financial press about “heightened volatility” in the stock market, it is a euphemism for “the sucker is going down!”. Naturally, with most market participants positioned for rising prices, especially when said prices are in nosebleed territory (stocks are always at their most popular when their valuations are nothing short of crazy), nobody likes that to happen – or let us rather say, only a small minority would welcome it.
This minority consists essentially of the following people: those who believe the market is overvalued and are either shorting it in the hope of profiting from a reversion to the other extreme (“mean reversion” is relatively rare in financial markets), or those who cannot bring themselves to invest in an overvalued market and are patiently waiting for the same event in order to be able to justify buying.
A chart demonstrating how persistent and intense the positioning for more upside is among mutual fund managers nowadays. While this is only one of the groups active in the market, it is probably a useful microcosm of general sentiment – click to enlarge.
The above explains why there is generally so little complaint about prices being distorted as long as it’s to the upside. However, when titles to capital are rising at a faster pace than other prices in the economy, it can only be for two possible reasons: the first is that people are saving more, in order to be able to consume more in the future. This is an expression of declining time preferences and lowers interest rates; this in turn will be reflected in rising prices for capital goods – the more distant from the consumption stage they are, the bigger the effect. Titles to capital will reflect that.
The other reason is that commercial banks, the central bank or more likely both are creating more money from thin air with the express purpose of lowering gross market interest rates artificially, thereby creating an unsound boom (while at the same time depressing the purchasing power of money over time, which explains the long-run upward tendency of asset prices). Obviously this is what has been happening most of the time since central banks have been around, and it has happened to an even greater extent since the monetary system has become a pure fiat money system, in which irredeemable money can be issued in any old quantity.
Since the latter method is so well entrenched, artificially distorted prices have become the “new normal”. The booms are much bigger and lengthier than they would otherwise be, and the amplitude of the busts is accordingly greater as well. Incidentally, the last bust has scared central bankers so much, that they are now eagerly working on creating the preconditions for a bust that will eventually put its immediate predecessor in the shade.
Anyway, one of the effects of this is that market participants, after bidding up prices to ever more dizzying heights for a while, have a tendency to discover the fact that they are unsustainable rather suddenly, in herd-like fashion. The repricing process from unsustainable, completely distorted prices to more realistic (i.e., lower) prices thus tends to happen faster than the preceding upside distortion process – et voila, “volatility”.
This is well known of course. There are no market participants who are not aware of this fact from experience. No-one should be surprised by occasionally seeing charts like this one:
The DJIA in 1987: a “discontinuous repricing event”, i.e., a great many market participants realizing all at once that they have overdone things in the boom phase – click to enlarge.
One technical reason why markets are rising a bit more slowly is precisely that short sellers are adding to the supply of stocks available for trading – this is a good thing, as it works against price distortions becoming too large too fast. On the other hand, judicious short sellers occasionally need a reward, otherwise they have no reason to play the game – and the game would undoubtedly be poorer for their absence.
Blackrock Has Other Ideas
As stressful as these discontinuous repricing events are for many market participants, it is a fact of life that they happen. They are the price that is paid for everybody agreeing with the premise that central planning agencies should fix the most important price signal in the economy, with a perennial “easy money” bias assumed to be the optimal stance to boot.
With the growing “financialization” of the economy as a result of the fiat money system’s unfettered expansion of money and credit, not only a number of “too big to fail” banks have come into being, but also a number of truly colossal “buy side” financial companies in the form of asset managers overseeing vast amounts of money. In fact, some of them have become such weighty players, that they have been chosen to become counterparties in certain central bank operations (both in outright securities purchase programs and repo operations).
In short, they have obtained a number of privileges that were previously the sole preserve of the banking cartel. One of these companies is Blackrock, and given its size and importance as a big player, it occasionally comments on market-related matters. It is safe to say that Blackrock is not very interested in seeing upside price distortions corrected, least of all quickly. What to do? According to a recent Bloomberg report, Blackrock believes “volatility” (i.e., markets going down) should be outlawed, by the expedient of simply shutting the markets down if it threatens to happen:
“BlackRock Inc., the world’s biggest asset manager, has its own remedy for days of extraordinary volatility in the U.S. equity market: Shut it down. Among the fund company’s suggestions: The entire $23 trillion market should automatically come to a halt if a certain number of shares stop trading, giving traders time to regroup on a wild day, according to BlackRock. Tweaking the rules on halts and making all stock openings electronic are among other ideas in a paper published Wednesday by the firm.
BlackRock’s proposals come as money managers talk with market-makers and stock exchanges to identify what happened amid the market turmoil on Aug. 24 and how to prevent a repeat. Trading that day was disrupted by delayed openings, more than 1,000 halts, and wild price swings. The fund company believes that many of its recommendations can be adopted with a minimum of fuss.
“They’re all very doable changes without a whole lot of magic,” Barbara Novick, co-vice chairman of BlackRock, said in an interview. “I don’t think they’re going to be contentious. I don’t think they’re going to be difficult.”
BlackRock is among several asset managers, including Vanguard Group Inc. and State Street Corp., that in recent weeks held discussions with market participants about the events of Aug. 24, people with direct knowledge of the matter told Bloomberg News. The talks highlighted factors including the use of so-called stop orders by investors, the role of market makers in pricing ETF shares, and narrow price bands used by the NYSE Arca exchange for opening securities, said the people. The issues were so widespread that about one in five exchange-traded products were halted during that day, according to BlackRock.
The talks between ETF issuers and traders and exchanges looked at the role of market makers in pricing ETF shares when some underlying stocks weren’t open or were seeing extreme price moves. Ways to better calculate an ETF’s share price amid turmoil have been discussed.
The BlackRock paper said that a quarter of the stocks in the Standard & Poor’s 500 Index hadn’t opened by 9:40 a.m. on Aug. 24, 10 minutes after the start of trading. BlackRock’s Novick suggested that in situations where a chunk of the stocks that make up the main index are closed, halting the entire market might be a good idea. The wildest fluctuations on a bad day could be limited if a circuit breaker stopped all trading, she said.
“In that scenario, you’d rather have had a market-wide halt to get everything back together than not have one,” said Novick.
Needless to say, if this really “worked” (it wouldn’t), it would make for a truly boring market. We are actually among the people who welcome volatility (in both directions), as we see it as a profit making opportunity. We couldn’t care less whether Blackrock likes it or not.
Such attempts to “regulate” everything, even the price swings markets are allowed to make, are attempts to stem oneself against nature. It is not unnatural for large downward price swings to occur in a market that has been distorted to the upside – ironically driven by yet another attempt to disturb the natural order of things, namely central bank price fixing.
Such exercises are therefore completely futile. We thought recent events in China’s stock market have demonstrated this rather clearly. Is there anything China’s authorities have not tried to “keep volatility” (read: falling prices) at bay? Well, they haven’t complete shut down the market, but they sure did try everything else that came to mind (ranging from none-too gently “persuasion” of large financial players to throw billions at the market and not sell any stocks, altering margin rules, halting trading in a vast percentage of listed stocks, threatening “evil short sellers” and journalists writing negative things about the stock market with fines and/or jail, and so forth).
Shanghai Composite, daily. No amount of intervention could keep the market from going where it needed to go, and fast – click to enlarge.
So China’s authorities threw everything and the kitchen sink as the saying goes at “volatility”, but they still couldn’t keep the market from crashing. As a matter of fact, such measures often tend to have the opposite effects of those intended. Take for instance the attempt to lock certain market participants into the stocks they were holding by telling them they better not sell, or else. Who in his right mind would still want to buy stocks voluntarily after hearing that? One risks ending up in a proverbial roach motel after all.
Another exercise in futility of relatively recent vintage were the short selling bans of financial stocks imposed in 2008 (which for some reason included even IBM as we recall). This produced the biggest two day rally in history (in points). This retroactive rule change managed to hurt short sellers immensely, but that was all it “achieved”. The crash followed right on the heels of that rally, so the joy among the intended beneficiaries was a short-lived affair.
It is likely to be similar with complete trading halts designed to “let traders cool off and regroup”, in the hope that upon reopening, the market will magically have ceased to be “volatile”. This is simply not how these things happen – we believe it completely misconceives human nature.
Sharp downside moves are not arrested by simply interrupting and postponing trading. What arrests them is a price decline that is steep enough to entice buyers to step in (both covering short sellers and bargain hunters). Trying to prevent the required price decline will simply postpone their appearance on the scene. It will also postpone the selling of those eager to get out, but it won’t stop it. They are wont to become even more panicked, simply because they fear being unable to sell due to more frequent trading halts. Here is what the action on August 24 looked like:
DJIA on August 24, 10 minute candles. We fail to see the problem – since when is an opportunity a “problem”? – click to enlarge.
If you read the entire article at Bloomberg, there is also a discussion of stop loss orders and their propensity to exacerbate downturns due to the alleged inability of people to “understand” how they work. We would argue that only illiterate morons don’t know how stop orders work, since as soon as one enters a stop loss order without a limit, a written reminder pops up in trading software provided by brokers describing how precisely they work and warning of potential unintended outcomes. So one has to be unable to read in order not to know, in which case one should perhaps not be trading anyway.
We would argue the main reason for Blackrock’s attempt to persuade the exchanges to adopt its recommendations on trading halts is that Blackrock itself is inconvenienced by downside volatility. Presumably the company is no stranger to leverage (how else can it squeeze out large returns with a portfolio this large in a ZIRP world?) and is therefore forced to exercise stop loss orders itself when the market declines fast. Its loss is however the gain of those who step in to buy on these occasions. Why should they be inconvenienced for having exercised patience and prudence?