A recent bump in market volatility underscores “why investors should mistrust serene markets,” according to a recent article in The Wall Street Journal.
On Wall Street, the article explains, market calm can result from “swarms of investors betting against volatility” rather than from organic factors reducing volatility such as improved trade relations and/or geopolitical calm.
Earlier this month, the article reports that the Cboe Volatility Index (VIX) hit an eight-week high after reaching its lowest level in a year only a week before–which led Ray Dalio’s hedge fund Bridgewater Associates to purchase $.1.5 billion in options “to protect itself against the risk of a near-term equity selloff.”
But in the current low-interest rate environment, the article notes, most investors aren’t following suit, which over the past few years has resulted in increased demand to sell options whenever the market calms—which then causes the VIX to plummet and the markets to be lured into a “false sense of security.”
In other words,” the article explains, “whereas in the real world more insurance against tornadoes doesn’t reduce the frequency of tornadoes, on Wall Street it does. The problem with this feedback loop is that when a tornado finally shows up, perhaps in the form of bad news about the economy, volatility shoots up violently as the bets all unwind together.” It cites the example of 2018, when “a so-called ‘volpocalypse’ wiped out retail tracker funds that were betting against volatility.”
“In today’s market,” the article concludes, “calm is treacherous.” While it stipulates that a market crash is not imminent and fears of a full-blown recession in the U.S. are receding,” it contends that “Given the precedents of what happens when bets against volatility build up, market bulls and bears alike are wise to expect a few bumps over the coming months.”