“Never think that lack of variability is stability. Don’t confuse lack of volatility with stability, ever.”
- Naasim Taleb
The Volatility of asset prices is one of the more challenging things to comprehend for many stock market operators. Price is easier to grasp, as you can see it tick every second (or more). Same thing goes for Volume as we can count the shares traded. Volatility, on the other hand, is often opaque and assumption laden (especially projected volatility).
The simple fact is that different stocks, industries and asset classes also have different levels of inherent volatility. Implicit to this is also that volatility levels change with time. Sometimes volatility shifts are episodic and non-trending, while other times they are trending.
Over the past year, we’ve had some highlight reel examples of episodic and non-trending volatility. Late January, late February, mid-May, and, of course, late September all come to mind. They were textbook examples of episodic and non-trending volatility.
Now Nassim Taleb might have you believe a “Black Swan” is lurking around the corner of every volatility spike. But we as stock market operators, have critical choices to make in those periods. Do we puke at the bottom? Or do we scale up our positions when there's blood in the proverbial street?
Stock market volatility triggers emotions. When volatility spikes and stocks sell off, many people understandably become scared and act accordingly. Some basics of behavioral bias are at play in these situations.
First, we often become guilty of extrapolation bias. In effect, when the equity market becomes more volatile in the short-term, we begin to believe that volatility will subsequently increase and the market sell off will continue.
Second, loss aversion takes over and investors become more likely to try and avoid losses. This pain of losing is twice as powerful as the pleasure of gains! In these situations, we get the “sell at any cost” type of equity declines.
Our view of volatility is slightly different.
More often than not, spikes in volatility likely create a buying opportunity, especially if they occur in a favorable economic environment (Quads 1 → 3) and do not become trending (remain bearish on a TRADE basis). As I noted above, we have seen this play out in spades in 2021. Imagine if you rushed for the proverbial exit with your portfolios in each of the volatility spikes this year...
Back to the Global Macro Grind…
In the post pandemic era, we have seen volatility also play out in reported economic data. In part, this is due to some of the easiest comparisons we have seen in a lifetime paired with the ebb and flow of COVID cases. The disconnect that has risen between Non-Farm payrolls and the ADP report is a good example. Historically, they have moved somewhat in lockstep, but much less so post-pandemic.
One of the more interesting examples of volatility we’ve been following relates to inflation (no surprise!) and the widening disconnect between CPI (consumer facing inflation) and PPI (producer inflation). Almost anywhere we look around the globe, the spreads between CPI and PPI are currently as wide as they have ever been:
- Turkish CPI – PPI spread currently stands at -26.4, while the average divergence since 1995 is -0.33;
- U.S. CPI – PPI spread currently stands at -6.4, which is the largest divergence since the start of the data set in 1991 and well above the average of +0.32;
- China CPI – PPI spread is at -12.0, which is again the largest divergence in the history of the data set and well above the long run average of +0.94;
- Finally, the Eurozone PPI – CPI divergence current sits at -12.6 as compared to the long run average of +0.07.
In some instances (like the spike in natural gas in the Eurozone) there are non-trending factors at play. But the reality remains that most of these spreads are 3 – 4 standard deviations beyond the norm. So, while some of these divergences may recede, the leading indicator nature of PPI to CPI will certainly keep the latter elevated.
The reality of post-pandemic economic data volatility is that it also creates interesting outliers. Take last week’s Michigan Consumer Confidence reading as an example. This November report declined from 71.7 to 66.8 sequentially. It was also a decade low reading in the data series.
So, has the state of the consumer deteriorated meaningfully in the last two weeks since the Conference Board’s report on Consumer Confidence? Probably not.
The Michigan report surveys a smaller number of respondents and has a pattern of being more volatile and disconnected ever since the pandemic began. This disconnected aspect was emphasized in the very strong retail sales for October earlier this week, which accelerated from 13.9% Y/Y to +16.3% Y/Y.
In a global pandemic world, we should be prepared for more volatile asset prices and economic data. The challenge for us as investors will to continue to discern between what is episodic and non-trending (or outright outliers) and what is trending. If we do, alpha opportunities will be plentiful.
This point even relates to COVID cases themselves. Currently, we appear to entering a mini-spike in global COVID cases with global cases +7% in the last 7 days versus the prior 7 days, U.S. cases +13% in that same period, and many European countries up a lot more (Germany +38%, France +38%, U.K. +15%).
This increase in cases too shall pass, but with it the economic volatility will likely only be exacerbated.
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets:
UST 10yr Yield 1.43-1.68% (bullish)
UST 2yr Yield 0.38-0.58% (bullish)
SPX 4 (bullish)
NASDAQ 15,620-16,130 (bullish)
RUT 2 (bullish)
Tech (XLK) 163.96-170.20 (bullish)
Utilities (XLU) 66.04-67.79 (bearish)
Energy (XLE) 56.58-59.26 (bullish)
Financials (XLF) 39.50-40.46 (bullish)
Shanghai Comp 3 (bearish)
Nikkei 29,008-29,998 (bullish)
DAX 15,938-16,301 (bullish)
VIX 15.08-18.87 (bearish)
USD 93.60-95.93 (bullish)
EUR/USD 1.127-1.153 (bearish)
Oil (WTI) 77.11-84.55 (bullish)
Nat Gas 4.60-5.67 (bullish)
Gold 1 (bullish)
Copper 4.21-4.48 (bullish)
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research
