Multi-Asset Strategies to Capitalize on Rising Uncertainty: Buy Volatility

Today's markets have become increasingly divorced from economic reality, thanks largely to central bankers too scared to address debt-driven growth challenges. Instead, they’ve implemented policies under which synthetically low interest rates and an endless credit convalescence is the new norm. This only leads to artificially inflated credit and equity markets, capex atrophy and an institutionalized misallocation of capital. Investors, retail and institutional, as well as the general public, are becoming increasingly cognizant of the risks pervasive throughout the global financial system.

A prudent investor would be wise to structure his portfolio to protect against any major drawdowns resulting from a collapse in the equity and credit markets. It isn’t a matter of whether markets will correct, it’s simply a question of when. And as we have learned, it’s nearly impossible to predict the actions of central banks…I know, Yellen has begun to sound like a broken record at this point, but this could shift at any time, and forecasting precisely when this might happen is a difficult endeavor. This article addresses ways in which investors can prepare for the coming correction, despite a lack of knowledge as to its timing, while also enabling continued participation in pre-correction upside.

The solution: buy volatility. When I refer to “buying volatility,” I’m referring to betting on a continued increase in global skepticism and market uncertainty. This can be executed in several ways, but I propose a relatively simple approach. While keeping core, long-term equity holdings for which you have strong long-term conviction, you can also purchase call options on the volatility index (the $VIX). As long as volatility continues to rise, these calls should increase in value and can offset losses on equity holdings when a correction eventually materializes. Another metric to track is the $VVIX, which is the derivative of the $VIX. The $VVIX measures volatility in the $VIX, or the underlying volatility within the volatility index (i.e. the 2nd derivative of the volatility in the actual equity markets). With the purchase of call options, you have an asymmetric payoff profile: you pay a premium and only this premium, and in exchange you have the option to purchase the $VIX at a pre-determined price over a specified timeframe. Asymmetry in the payoff profile results from the limitation on downside risk (with losses limited to the premium paid) and virtually unlimited upside potential (though in the case of the $VIX, volatility can only go so high, so naturally there’s slightly less asymmetry relative to, say, call options on a given stock, for instance).

Why should we prepare ourselves for a major Equity/Credit Market Drawdown?

As mentioned previously, today’s global markets have become increasingly divorced from reality. In the U.S., Washington is unable to make critical structural changes, as it stands gridlocked while our nation’s biggest economic competitors – China, Russia, and the oil-producing nations of the Middle East – are doing everything possible to end U.S. monetary hegemony. Risk has surpassed levels seen in the history of trading as we know it, yet markets have hardly made any real adjustment.

Overarching Macro-Level Indicators Point to a Deep Recession and Lengthy Recovery

While the global market confronts a minefield of risks, one of the most threatening is that of over-leverage. Leverage levels and derivative exposures outstanding today are, by order of magnitude, larger in scale relative to any in history. Today, gross derivative exposure globally is greater than 9x global GDP. Does this make any sense in a fundamentally-driven market? No, clearly not. If all investors were keen to today’s true risk overhang, both equity and credit instruments would be valued at levels far below current prices (which have been propped by what seems to be a never-ending period of ultra-accommodative monetary policy).

Over-leverage and insolvency issues do not create themselves. Over the last decade and more so in the recent 6-7 years, the free money era has prevailed among global central banks. It first began with the Fed’s implementation of massive quantitative easing, allowing newly created dollars to roll off the Greenspan/Bernanke printing press for years on end. As the dollar became increasingly cheap, emerging market governments (and companies) took advantage of the opportunity to borrow cheap USD, but forces are now moving in the opposite direction. As the Fed looks to reverse its hyper-accommodative monetary policy, the dollar is strengthening while many emerging market currencies are being devalued. To make matters worse, these countries often produce largely commoditized products heavily reliant on demand from China, which is growing much slower than anticipated. As the impacts of both weak currency values (and thus weak operating profits relative to the value of dollar-denominated debt service requirements) and declining demand pressure these emerging markets from all angles, they’re approaching default at a rapid clip. Further strengthening in the dollar could be the straw that breaks the camel’s back. It could drive an unraveling in the domestic and international credit markets, which would leave in its wake great wreckage in global equities markets.

A similar dynamic, that of overleverage, has taken place in the domestic consumer and small-to-medium-sized business (SMB) lending markets, as institutional investors with masses of cash fight for qualified borrowers after the Fed flooded the market with liquidity. This simply represents a shift in the risk factors leading to the financial crisis of 2008 away from major bank balance sheets and into the “shadow banking” system (discussed further below). As one of many examples, the market for student debt obligations has imploded, with defaults far higher than anticipated, after total outstanding loans expanded beyond the $1 trillion mark. Many graduates simply cannot afford to repay their debts, understandably so given the sluggish wage growth in the domestic economy.

Hedge funds and other institutional investors that previously occupied the publicly traded credit arena have moved down the lending spectrum, looking to SMBs and consumer lending as an outlet to generate returns as the domestic Corporate and High-Yield (HY) debt markets became highly frothy, with HY debt trading far above historic norms relative to the associated risk. Note that while this dislocation has recently begun to normalize, as high-yield spreads have tightened and interest rates have risen, the private lending markets remain crowded. In fact, competition for qualified borrowers in the private lending arena has skyrocketed. With greater competition comes lenders willing to accept lower interest rates and implement lax underwriting standards (covenant-free, or with covenants that aren’t checked without trigger-event such as default), and a battle for unqualified borrowers who would, under normal circumstances, be denied credit (due to an unhealthy balance sheet, poor credit history, or some combination thereof).  We’re now seeing a similar occurrence in the auto-lending market, which just surpassed $1 trillion in outstanding loans (akin to the student-debt dilemma) issued to a basket of borrowers whose credit ratings are far from stellar.

When referring to the credit markets, Bloomberg recently indicated:

“Defaults will breach the historic high next year and the Fed is the ‘wild card’ that has the power to determine how quickly the current credit cycle ends.”

To summarize, massive debt levels have thrown us into a vicious cycle characterized by fundamentally imbalanced markets. The next great crisis will be of unprecedented magnitude, given an unprecedented debt burden (we can thank Bernanke, Greenspan and their fellow colleagues at the FOMC for this) and excessive derivative exposures (equivalent to 9x global GDP). After witnessing the global meltdown of 2008, one would have hoped the Fed and other regulators (as well as market participants) would’ve learned a critical lesson: debt can present an enormous drag on economic growth and has the potential to take down the entire system. Instead of addressing growth challenges head on, like a heroin addict the illustrious members of the Federal Reserve (in addition to several other central banks) pulled out the syringe and said “hey, let’s work our way out of this mess the way we started it.” Today there is a new conventional wisdom: “we can always print our way out of the debt-trap, by simply creating new money and issuing ever more debt”… pure genius. The optimists never falter and will argue that faith in the US dollar and fiat currency as a whole can never be broken, no matter how high our national debt or how dysfunctional our government. This argument demonstrates a lack of real thought and/or basic logical reasoning.

After the implementation of Dodd Frank following the 2008/09 financial crisis, regulations limiting commercial bank exposures to “assets” that are essentially bad debts helped remove some of the problems with major bank balance sheets, though derivatives exposures and counterparty risks are still pervasive and pose a serious threat to the system. As an example, global derivatives exposure on a gross basis (not to be confused with net exposure, a metric often misused to measure risk) is greater than 9x global GDP. This reflects major distortion in the global financial system, and risks far higher than are generally perceived by the investing marketplace.

The Shadow Banking System and its Role

While Dodd Frank helped resolve some problems with major banks’ balance sheets, the risk exposures have simply shifted away from the large banks and into the “shadow banking system.” Shadow banking refers to the activities of financial intermediaries who partake in credit intermediation outside the regular banking system, thus lacking a policy-driven safety net. The largest shadow banking systems are found in the developed markets or “advanced economies,” but these institutions are growing more rapidly in the emerging markets. While “shadow banking” takes vastly different forms across and within countries, some key drivers behind its growth are common to all: tightening banking regulations accompanied by ample liquidity conditions, as well as demand from institutional investors loaded with cash and a mandate to put it to work in the credit markets. As I mentioned previously, in the U.S. this is represented by hedge funds and private debt investors vying for stakes in debt syndication deals with private, small- and medium-sized businesses in exchange for yields that are mediocre at best. According to a publication by the International Monetary Fund (IMF) this month, “the current financial environment in advanced economies remains conducive to further growth in shadow banking.” In the report, the IMF notes shadow banking constitutes roughly one fourth of total financial intermediation worldwide, and has the largest presence in the United States, the Eurozone and the UK. We are particularly exposed in the U.S., as the only region with shadow banking assets that exceed those of the conventional banking system.

Broad Shadow Banking Measures by Region

Overleverage and insolvency issues are also a problem throughout Europe and Japan, and this isn’t the first time either region has seen problems of this nature. Europe and Japan are each uniquely distorted markets, and together reflect the magnitude of the markets’ failure to properly allocate capital.

Let’s start with Europe. The ECB, prior to announcing a QE program to buy up ~EUR1.2 trillion+ of government and private debts, chose to experiment with negative rates. It was the first central bank to venture into this uncharted territory, bringing its deposit rate to negative 0.2% in September 2014. This effectively punished the conservative banks for holding decent levels of cash with the central bank instead of extending loans to businesses or weaker borrowers. Sweden implemented a similar combination of negative rates and bond buying. Denmark pushed rates deeper into negative territory to protect its currency peg to the Euro, and Switzerland moved its deposit rate below zero for the first time since the 1970s. As central banks provide a benchmark for all borrowing costs, negative rates spill-over to a range of fixed income issues. By the end of March of this year, more than a quarter of debt issued by Eurozone governments carried negative yields, meaning investors who hold these positions to maturity will not get all their money back. With the actions of the ECB, many Eurozone banks elected to pass negative rates onto their customers.

Imagine a bank that pays negative interest. In other words, it gets paid to borrow money, and depositors are actually charged to keep their money in an account. Crazy as it sounds, several of Europe’s central banks have cut key interest rates below zero in a bid to reinvigorate an economy with all other options exhausted. No matter how you swing it, this is an unorthodox approach that has created distortions in the financial marketplace.

Negative interest rates are a sign of desperation, the most obvious signal that traditional policy options have proven ineffective, thus new limits must be explored. Despite the obvious artificial inflation that results from such policies, European markets continue to respond positively to these accommodative monetary developments – as noted previously, it is the new conventional wisdom: When all else fails to spur growth, create new money and buy bonds.

Europe: Did we forget about Basel I-III?

What was the point of the Basel regulations??? They were intended to bring banks across the Eurozone, primarily those in Spain, Portugal, Italy, and France, to clean up their balance sheets and avoid "toxic" corporate risks. As such, the laws limited the amounts of corporate debt these banks could hold on their balance sheets, resulting in banks' offloading these "high-risk" assets, often at fire sale prices (scooped up by private equity/debt players out of the U.S., the U.K., and Europe). Now, all of the sudden it's a positive indicator that European banks are forced to retreat when it comes to underwriting standards?? This is a plan certain to backfire.

Tumbling rates in Europe have put some banks in an inconceivable position: owing money on loans to borrowers. At least, one Spanish bank, Bankinter SA (OTCPK:BKNIY), has been paying some of its customers interest on mortgages by deducting the negative interest from principal balances owed by its borrowers (WSJ). This is only one of many challenges caused by interest rates falling below zero (which makes no sense, to start). Throughout Europe, banks are now being compelled to rebuild computer programs, update legal documents and rebuild spreadsheets to account for negative rates. Interest rates have fallen sharply since the ECB introduced measures last year to reduce its deposit rate, and in March launched a new massive QE program targeted at buying public and private bonds (to the tune of EUR 1.2 trillion, in EUR 60 billion monthly installments), driving down yields on Eurozone debt with the intent to foster heightened lending. The image below depicts how this situation may occur (and is occurring) as Euribor has fallen into negative territory.

In countries such as Spain, Portugal, and Italy (key countries with undercapitalized bank balance sheets leading up to the Basel regulations), the base interest rate used for many loans, especially mortgages, is based on a spread over Euribor. As rates have fallen, sometimes below zero, banks face the paradox of paying interest to their borrowers. Even still, the market and the great members of the ECB view loosening credit standards as a positive? Remind us of the driving force behind the Basel regulations...

Banks are turning to the central banks for guidance, but what they're receiving is less than comforting.

Portugal's central bank ruled its banks would be required to pay interest to borrowers if Euribor plus their stated spread on existing loans falls below zero. Over 90% of the 2.3 million mortgages outstanding in Portugal have variable rates linked to Euribor (WSJ). Most mortgages in the country are linked to a monthly average of three- and six-month Euribor, both of which have been steadily declining and currently hover just above zero.

Additionally, in Spain (another problem area in the Eurozone), the vast majority of Spanish home mortgages have rates that rise and fall tied to 12-month Euribor (according to statements issued by Spain's mortgage association). That rate stands at 0.139%, down 126% over the last half-year, from 0.187% in mid-April.

Finally, another country that only recently began to pull itself out of a banking debacle (Italy) carries about half of its mortgages on variable rates linked to Euribor. Existing loan contracts do not stipulate how to proceed in the event Euribor falls into negative territory.

Two-month Euribor is at negative .072% (dropping 1600% since its mid-April rate of negative .004%). Hundreds of thousands of additional loans would be affected if medium-term Euribor rates enter negative territory; the six-month rate currently stands at 0.027%, significantly lower (down 165%) than its prior level of .078% in April (2015).

Central Bankers & Economists: Losing the Forest from the Trees

A one-month positive data point out of the Eurozone, be it rising industrial production in a given nation, stronger employment, higher GDP or the like does not mean the economy is on a rapid upswing to move out of its troubled position, nor can we say with certainty the ECB's QE buying has anything to do with it. There are several complex interrelationships at play, and monthly output data can be volatile. Interpolating what the ECB might do with its EUR 1.2 trillion QE program due to a single monthly data point is a flawed approach. Europe still has more than its share of structural issues to address before it can truly be confident about long-run growth prospects.

After any (often minor and meaningless) positive data releases, economists begin to speculate as to whether the ECB will begin to signal its satisfaction with a supposed pickup, and how this might affect the longevity of its EUR 60 billion (per month) bond buying program. In turn, this impacts how other central banks respond.

Where Central Banks Should Direct their Focus

Central banks such as the ECB, Japan's BoJ, the UK's BOE and the U.S. Fed should redirect their attention from short-term, often volatile monthly data figures and open their eyes to the obvious, long-term market distortion their actions have created. With repeated communications and actions suggesting markets can simply be manipulated to spur growth through printed money in numerous countries and various currencies, how long can we rely on the true value of fiat currency? The system has driven itself into believing in its own stability, which in actuality is non-existent.

Groupthink has muddled our views as to how financial markets should behave. A lack of fundamental economic growth, masked by debt-driven financial growth, does not resolve any underlying issues. Instead, unsustainable QE and Zero Interest Rate Policy (ZIRP) and the subsequent high (and growing) nominal levels of stock and bond markets have led investors on the hunt for yields, buying assets of increasing risk without consideration of balance sheet health and/or weakening fundamentals.

We should be critical when assessing those who act as Fed proponents, with the only consistent argument being "well, what would you suggest the central banks do differently?" How about not allowing money to become so cheap that countries and, in some cases, corporations and individuals (as described above in the Eurozone) get paid to borrow. This is simply beyond the realm of sanity, and it puzzles me how many cannot understand this. How about central banks stop reminding the world that they can never run out of money, thus providing an infinite number of excuses to do nothing on the fiscal or structural side. 

"One should not mistake the wanton creation of money [for] omnipotence" (Anne Stevenson-Yang re the PBOC).

The same logic could be applied to the BoJ, the Fed, the ECB, et al. It's time to return to credible monetary policies that are sustainable over the long-run and pass the ball into the fiscal court. If that means the economy must suffer some dire misfortunes, then so be it. We have created the means of our own demise. From a fellow Seeking Alpha reader's comment (thanks Chrislund), "Treating the financial system as an endless credit convalescence only leads to capex atrophy. Synthetically low interest rates designed to surrealistically suppress the cost of capital for this many years is a surefire way to institutionalize the misallocation of capital."

Recent Data Suggests Recession may be Imminent

Global GDP is clearly slowing, and data we’re getting from the U.S. suggests we’re likely to see a major fall-off in GDP in the coming few quarters (following the worst quarter in years for equity markets, 3Q 2015). One should evaluate the recent employment data (which was quite disappointing, to say the least); earnings forecasts (and some shifty accounting); credit spreads; total leverage in the system; and the overall credit environment. Ephemeral, debt-driven or financial growth has supported economic growth measures for some time now, masking a deterioration in actual, fundamental growth. This data, in the aggregate, suggests we should be on “recession alert” (John Mauldin, October 4, 2015), “because a recession will mean a full-blown bear market (down at least 40%), rising unemployment, and (sadly) QE4.”

Some information provided by Reuters regarding current valuations and growth expectations:

“Even with the recent selloff, stocks are still expensive by some gauges. The S&P 500 Index is selling at roughly 16 times its expected earnings for the next 12 months, lower than this year’s peak of 17.8 but higher than the historic norm of about 15.”

“Moreover, forward and trailing price-to-earnings ratios for the S&P 500 are converging, another sign of collapsing growth expectations…The last period of convergence was in 2009 when earnings were declining following the financial crisis.”

Analysts are now calculating earnings estimates “ex energy,” typical as energy has been the biggest drag on earnings. If we’re removing the bottom outlier, Mauldin points out, shouldn’t we too remove the top outlier? Healthcare has carried much of the earnings burden for the S&P, so wouldn’t it be prudent to calculate and evaluate earnings projections on an “ex energy,” “ex healthcare” basis? Mauldin also cited an unusual trend as of late:

“A funny thing about earnings: they’ve been going up for the past year, even as top-line revenue has not. Generally, those go hand-in-hand. What’s happening?”

This is likely due to simple earnings manipulation by corporate accountants. It’s easy to move expenses from one period to the next (extend salvage values and useful lives of depreciable assets; re-characterize costs that are naturally recurring as “one-time, non-recurring charges;” estimate bad debt expense relative to receivables at a lower percentage than history has shown; push forward revenues by extending greater credit to less creditworthy borrowers (the auto sector is a perfect illustration); many accounting mechanisms are available to manipulate earnings in the short-term, but this in essence equates to “stealing” from future earnings when these loose accounting measures must be reversed as actual cash transactions play out. Some recent earnings appear to be those of the “smoke and mirrors type,” as Mauldin suspects.

Tesla Motors ($TSLA) is a perfect example. They’re the role model for earnings manipulation, with capex rising at an enormous rate, while depreciation expense relative to fixed assets and capex continues to decline (exponentially). Similar phenomena can be found throughout $TSLA’s financials, though I won’t get into the weeds here.

Finally, earnings forecasts are notorious for lagging the trend. If earnings are beginning to fall – as it appears they are – it’s highly likely earnings estimates will miss to the downside. If this occurs simultaneously with the economy dipping into recession, estimates could miss to the downside quite dramatically.

Recent Global Developments and Data Points

Inflation expectations are coming back down again in Europe, and is expected to support incremental QE from the ECB, bringing down the Euro a bit. As I write to you, the Chinese markets are trading up 3.3% on speculation the central bank will implement additional stimulus after a long holiday, reacting also to decline in China’s money rate (the most in a month) as the PBOC continues to inject money into the system.

In Germany, net exports for the month of August (2015) were just released. Results were quite ominous, particularly considering the other German data points received over the past few days, with total exports down 5.9% versus consensus estimates for exports up 0.9%. Moreover, Germany’s largest investment bank, Deutsche Bank, braces for a 3Q print with a loss of ~EUR 7B, the largest loss in at least a decade. Analysts and investors are concerned the company may cut its dividend, which has never been cut since Germany’s post WWII reconstruction. Despite the negative print, the stock is trading down by a meager 1%+.

Implications from German export data are interpolated into Chinese demand trends, and given the huge miss in Industrial Production figures and August Exports the release has spooked emerging market investors. Emerging market trading is following the downtrend, as Germany’s weak export data solidifies the growth woes discussed previously by the IMF in addition to its statements regarding fragility in the global recovery.

In the Eurozone as a whole, investment rates are running well-below replacement levels, despite historically low interest. This suggests problems in the region are more structural and systemic in nature, and could persist longer than the markets anticipate.

In the U.S., particularly troubling developments relate to continued ultra-high monetary accommodation coupled with stagnant wage growth and employment participation levels well-below historic norms. If, for example, you looked at the U.S. economy and employment situation 25 years prior to the 2008 crisis and extrapolated current employment levels, one would anticipate employment around 63-65% (versus 59% actuals). Additionally, in the latest two reports year-on-year wage growth came in with the lowest figures in the last 25 years.

How Can Investors Address these Risks in Portfolio Management?

Global uncertainty in both the credit and equity markets is rising, and deservedly so. So how do we, as investors or investment managers, avoid following the herd by making investments that clearly have no fundamental basis, without losing out on potential upside as the market’s coalescence of views as to the new norm continues to persist? Said differently, how do we participate in the upside (as market participants continue to behave irrationally) while protecting our portfolios from massive drawdowns when the chickens come to roost?

One approach is to utilize a multi-asset strategy designed to hold equities but also protect the overall portfolio from downside by buying market volatility. This can be executed in several different ways, and one must be careful in doing so to ensure allocation is aligned with risk tolerance. When I refer to “buying market volatility,” I refer to purchasing call options on the volatility index, or the $VIX, such that as global uncertainty continues to rise pending a market implosion, these options climb exponentially in value and thus offset to some extent any losses on long-term equity positions. If one was a complete risk taker with high conviction the prevailing levels of market dislocation will soon reverse, they might remove all exposure to equities and simply buy calls on the $VIX, betting that uncertainty will only get worse and thus volatility will continue to rise. As market behavior and asset values become increasingly divorced from economic realities, the case for such a strategy is incrementally solid. Please note, however, that solely purchasing calls on the $VIX is a risky strategy with the potential to lose your entire investment, so it is recommended that you adjust your approach to buying volatility to ensure it is consistent with your intended portfolio risk profile.

A way to measure volatility before it materializes in the $VIX can be interpolated by looking at the trend in its 1st derivative, or the $VVIX, which measures volatility in the VIX and surged to an all time high one day about a month back (in early September), as shown below. With that kind of volatility in the index, which represents the 2nd derivative of volatility in actual equity markets, one could expect some real volatility in our near-future. Investors holding $VIX calls that day made out like bandits, so if strange volatility events like that depicted below continue to occur (or even if it occurs only one time, while holding options on the $VIX), this could be a particularly lucrative approach.

Bloomberg Chart: $VVIX Trading (March 2014-September 2015)

In summary, long $VIX calls are a viable option to continue to hold long-term high conviction equity positions, so as to preserve upside prior to a market collapse but to simultaneously position yourself such that when the collapse does eventually materialize, volatility will skyrocket, as will the value of your $VIX options. Another big plus with long call options positions is their inherent leverage, without requiring the same level of risk that would typically be required to obtain similar leverage say, using futures, for example. Each single option covers 100 units of the underlying asset (in this case, the $VIX), so even minor fluctuations in the right direction can translate to relatively fruitful returns. With this structure, gains on your long volatility calls would offset losses on the portfolio's equity allocation, provided the options positions are sufficiently large relative to the total equity allocation.

But, I would like to emphasize once more, long calls are a risky strategy in that in the event they expire worthless, your return is zero and you have lost the premium paid, so please take my advice with due care and consideration for alignment with your portfolio risk profile. That said, call options have an attractive, asymmetric payoff profile with virtually unlimited upside, and losses are limited to the premiums paid.