TRADING INSIDER: Here’s Why Markets Should Be Wary At Times Of Low Volatility

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One of the big topics in the global markets at the moment is the lack of volatility – meaning simply, that prices aren’t moving around much.

Last month the S&P 500 had two of its narrowest trading days in history, with a range of just 0.24% and 0.25% of the index price of 1,964. These were just shy of the all-time low day in S&P 500 volatility of just 0.2% on December 30 2013.

Quiet times on markets have differing impacts on traders and investors.

What’s different and important about these two days compared to the list of the 20 lowest days according to our colleagues at Business Insider in the US is that the other days on the list have occurred on trading days which were close to holidays.

So you expect trading volumes and the market range to be low and small respectively.

For long term market participants periods like this, in which observed market volatility is extremely low, are unsettling. Not because low volatility and small ranges are bad things, but because small volumes and tiny ranges can, often and counter-intuitively, lead to more risk taking.

So a moderation in observed risk and volatility can actually set the scene for the exact opposite to occur at some point in the future.

It’s a version of economist Hyman Minsky’s financial instability hypothesis.

Let me explain.

Minsky said that the economy is essentially made up of three types of economic actors, units in his economist tongue. They are hedge units, speculative units and ponzi units.

Hedge units are your more conservative players. Families who buy a home to live in and pay off for 10 years or so. Investors who buy bank stocks with their capital for the dividend stream and some capital gain through time. These people can service any obligations to the investments, house, shares, commodities and so on out of cash flows unrelated to the investment.

Speculative units might have bought their NAB or BHP shares via a margin loan, so there is leverage, and they are reliant on some income from the securities to service the debt. But if there is no capital loss, it’s not a problem.

Ponzi units on the other hand are the traders who buy the RIO or WBC shares with a loan and need the price to increase to pay it back by selling and reaping a capital gain. If the stocks fall they are toast.

Naturally Minsky says when an economy becomes dominated by Ponzi units it is less stable and prone to crashes – hence the financial instability hypothesis.

If you are wondering why this is important in the current market environment the answer is two-fold.

First the US Federal Reserve policy of super low interest rates and cash drops on the economy (and those of other central banks) is intricately tied to the positive returns in stocks since 2009.

What’s also important is when the Fed wasn’t expanding its balance sheet after QE 1 and QE2, US stocks lost ground – substantial ground in 2011, when the Dow had a big fall before the Fed’s 3rd quantitative easing program, QE3, was eventually started with $85 billion of bond purchases a month.

The market once again picked itself up and began rallying suggesting, Minsky’s Ponzi units are driving the market.

So as the Fed continues to reduce the amount of cash it puts into the market each month, currently $35 billion down from $85 billion as it “tapers”. The signals are that rates will rise in 2015 and this is a warning that stock market gains may be at risk – if only short term.

What makes this doubly important is that at present, with low volume and low volatility, a level of complacency is creeping into markets.

Recently Business Insider and other publications like the FT and Wall Street Journal have reflected this market complacency with stories with headlines such as “This is what Wall Street looks like when no one is home”, and “Even the world cup can’t move markets”.

But why the market can become particularly unstable is because at times like these hedge units move to the side of the market, speculative units reduce their activity as well and we are left with ponzi units – day traders, hedge funds, algo traders, robots and scalpers – as the only players.

To get the returns these guys need to justify their existence and make a living at times of low volatility and tight trading ranges it can, often does, lead to bigger and bigger position sizes.
Which gives the preconditions for a black swan, an unexpected market event, to break traders from their slumber and these ponzi units to race to cover their positions.

It’s what happened to Nick Leeson and Long Term Capital Management.

This drags the speculators from the sidelines and eventually even the much more conservative hedge units – that’s you and me – back into the market.

And we once again have volatility, unexpected and spiking, as fear rises and begins to feed in itself.

Minsky’s financial instability might seem obscure to your average trader or investor, but at the end of 5 years of US Federal Reserve cash injections into the market and with volatility and ranges at record lows, it is a warning to be vigilant.

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