Signals and Noise and High Vol-of-Vol

January 29, 2015

Signals and Noise and High Vol-of-Vol Photo

The key to long term success as an asset manager is to have a convicted investment thesis, all the while watching market signals and filtering noise, remaining flexible enough to change your investment thesis should the signals demand it. This week, we will talk about the signaling from volatility of volatility, or "vol-of-vol."

Vol-of-vol is a measure of the market's perception of tail risk. If you look at the chart above, you can see vol-of-vol is currently at a very elevated level. This tells us that investors are nervous, worried about a shock in the market. This stands in contrast to the general consensus of an improving U.S. economy in 2015. (A better economy usually means a fairly quiet and less nervous market.)

We think a few forces are behind this heightened vol-of-vol:

  1. Distribution of risk changed after the aggressive monetary easing by policymakers all over the world. The easing reduces the risk around the body, but it increases the risk at the tail. More proof that there is no free lunch.
  2. Liquidity in the market is low. With heightened volatility, market makers' balance sheets are constrained, and a thin market is prone to sharp moves, as we witnessed recently in mid-October.
  3. The complex changes taking place in the global economic landscape has the market confused. To list a few of the changes: A sharp drop in the price of commodities, surprise from the Swiss National Bank, an economic slowdown in China, and deflation fears around the globe after monetary easing. It is hard for market participants to digest all these moving pieces, and this naturally increases the volatility of volatility in the market.

Key Takeaway: This high vol-of-vol is consistent with the negative yield we see in many sovereign bonds. The focus of many market participants is changing from "return on the money" to "return of the money". If we look at the difference between earning yield on equities (about 5.5% for the S&P 500 Index) and 10-year government bond yield (1.8% in U.S.), equity still looks like the better choice. But is "TINA" (there is no alternative) a good enough reason to buy equities?

Tags: Chart of the Week | Risk | Bonds | Stocks | Volatility | S&P 500 | 10-Year Treasury | Vol-of-vol

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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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