Authored by Mike Shedlock via MishTalk,
Axel Merk at Merk Investments discusses volatility and the next thing likely to blow sky high: Correlation strategies.
This Time is Different. Really?!
By Axel Merk
“Don’t panic, buy the dip, who cares?” or “These are rumblings of an earthquake, people will be hurt like in 1929” – which one is it? I would call it a wake-up call. Let me explain:
In recent years, markets had appeared eerily “safe”. Central banks promised to do “whatever it takes”, provided “forward guidance” to keep rates low, even printed money to buy government debt, calling it “quantitative easing.” Sure enough, volatility has been low, valuations have risen. Now, just as the fellow from the cartoon above, many might have thought something isn’t quite right. As a result, many investors have been looking to buy some insurance, protection, just in case this goldilocks environment doesn’t last forever. For those who have looked for ways to protect against a decline, they likely noticed that it had been rather expensive. Indeed, we had come to the conclusion some time ago that it may be more prudent for many investors to hold more cash rather than hold risk assets on the one hand, but then, say, buy put options in addition. However, cash in a 0% interest rate environment is not sexy (and holding cash a recipe for professional investors to lose client assets), causing many investors to have come up with ever more creative ways to “diversify.” We put diversify in quotes because many investors may be fooling themselves: many of those alternatives are reaching for yield and may well be risk assets in disguise, meaning they may be similarly vulnerable in a risk off environment.
One way to buy “protection” is to buy derivatives or exchange traded products that rise when volatility rises. The most direct way is to buy futures on the volatility index VIX; retail investors bought an exchange traded note that invested in such contracts; note that the underlying derivatives periodically (monthly) expire, so there is a continuous rebalancing between the nearest contract and those further out. Anyone who has bet on a rise in volatility through these instruments knows that you continuously lose money, unless you get the timing right. That is, it costs you at times over 10% a month for the right to potentially benefit when volatility rises. I say “potentially” because it isn’t even …read more