Volatility

The allegory of the Prisoners’ Dilemma

EXTRACTS FROM A PRESENTATION AT THE ‘8TH VOLATILITY AND TAIL RISK EDUCATIONAL EVENT’ HELD BY 36 SOUTH IN APRIL 2015

Christopher R. Cole is the founder of Artemis Capital Management LP and the portfolio manager of the long volatility biased Artemis Vega Fund LP. Christopher’s core focus is a systematic, quantitative, and behavioral-based trading of exchange-traded volatility futures and options. He previously worked in capital markets and investment banking at Merrill Lynch. Christopher holds the Chartered Financial Analyst designation, is an associate member of the NFA, and graduated magna cum laude from the University ofSouthern California.

The famous journalist Dorothy Thompson once said peace is not the absence of conflict; there is a form of peace and stability that is in fact reinforced on a foundation of underlying conflict and volatility. Game theorists call this the paradox of the Prisoner’s Dilemma and it describes a dangerously fragile equilibrium achieved through competition. It is also the most important concept to understanding modern markets.

Consider this: over 10 thousand years of human civilization and today is the best time to be alive in the history of the world. We have the most peace, the most stability, and the highest living standards. This comes simultaneously with great risk. Today we have the ability to destroy our planet through resource depletion, and we have the ability to destroy ourselves through nuclear Armageddon. We have the greatest stability with the largest tail risk in the history of human civilization. Peace exists exactly because of hidden conflict; this is Prisoner’s Dilemma.

Global Capitalism has reached its own Prisoner’s Dilemma; 44 years after the end of the Bretton Woods System Global central banks have manipulated the cost of risk in a competition of devaluation. We are nearing the end of a 30-year “monetary super-cycle” that created a “debt super-cycle”, a giant tower of babel in the capitalist system. Never forgot – peace is not the absence of conflict – peace can exist on the very edge of volatility.

So how do you define Prisoner’s Dilemma in life and modern markets? It describes when two purely rational entities may not cooperate even if it is in their best interests to do so. The perfect example of this is the Cold War. You have two super powers, the optimal scenario is disarmament and peace. But because the two powers do not trust one another, we follow the course of nuclear armament. This non-cooperation, this selfishness, this conflict, actually results in underlying peace, but with massive tail risk for human civilization.

Well, likewise, global central banks today are in an arm’s race of devaluation resulting in suboptimal outcomes for all parties and greater systemic risk. Globally they have printed over 11 trillion dollars since the end of the financial crisis. In this year alone over 20 central banks have devalued their currency trying to catch up with the US.

To this effect, the central banks of the world are trapped in a prison of their own design. If you are an investor you are trapped in this prison with them. If you are an endowment, if you are a pension system, if you are a retiree, you need a minimum return on your investments. And with every central bank devaluing, with all interest rates going to zero, it is becoming harder and harder to get that minimum return. Today the average expected return for a US state pension system is about 7-8%. Back in the nineties, you could achieve that with investment grade debt. Today, you are forced out on the credit spectrum, the risk spectrum, forced to buy high yield, use leverage, or short volatility. One fourth of the Bloomberg Eurozone sovereign bond index now has negative yields, and some corporate bond yields have now gone into negative territory. We have reached below the zero bound and it is unprecedented in the history of finance.

Risk assets have become entirely dependent on monetary expansion. Stock prices have risen in lock step with monetary expansion during the regime of the Prisoner’s Dilemma. US stocks now have the highest median price-to-earnings ratio in post-war history. We have cyclical PE ratios, Enterprise Value to EBITDA, and price-to-sales ratios on par with periods like 2000, 2007 and 1928. Companies in S&P 500 spend 95 percent of earnings on share buybacks. What is interesting is that since the end of 2012 there has been a divergence between commodity prices and global equity prices. So the global commodity super cycle seems to be breaking due to slower global growth, but risk assets continue to rise, showing an ominous divergence between the real economy and the surreal economy. There are those who say this is some new king of paradigm – the age of central banks – we’ve heard that before, in 1928, in 1999, hell, all the way back to 1716 with John Law in France – the original quantitative easing expert.

It’s different this time works very well to rationalize how to beat your return benchmark in the next quarter or for winning a political election. In the long term it is tragic.

You cannot destroy volatility, you can only shift and transmute it.

Central banks have taken asset returns from the future and brought them to the present, and they have taken tail risk in the present and shifted it out into the future. When comparing the probability distributions of the S&P 500 since 1960 and during the QE2 and QE3 regimes, you can clearly see that central banks have literally depressed the tails and increased the middle of the return distribution. You cannot destroy the volatility on the tails, you can only push it forward into the future.

All this is not free, it comes at the cost of massive global debt expansion. The world has not even begun to de-lever. In fact we’ve piled on debt and shifted private debt to the public balance sheet. Private risk to public risk. And this has occurred globally. According to a recent McKinsey study, the world reached 200 trillion dollars of debt in 2014, a staggering 40% increase from 2007. In China, debt has grown four times faster than GDP since 2007, and half of that debt is linked to their property. There is no precedent in financial history for a robust economic recovery absent either debt reduction or rampant inflation. Why is today different?

Central banks are trying to fight deflation. What is deflation? Interestingly, when population growth rates are increasing we tend to have inflationary episodes thereafter. When we have decreasing growth rates in world population, like we do today, we tend to have periods of lower inflation, or even deflation. So this begs a question – is deflation an economic or a demographic phenomenon? And if it is a demographic phenomenon, all of the debt and monetary expansion in the world is not going to solve that problem.

Whether we realize it or not, we are all volatility traders. And the world can only be split into two asset classes, long volatility and short volatility. Most of active management is just short volatility in sheep’s clothing. For example, strategies that rely on mean reversion such as traditional value investing, currency carry, pairs trading and statistical arbitrage become akin to shorting volatility. The common retail strategy of buying a stock on dips and selling on strength is literally part of the process for synthetic replication of a variance swap. Most of what you think is alpha is simply short volatility in disguise.

Imagine you are an alien that comes down from outer space – you know nothing about investing, you don’t know what a stock or a bond is – all you have to look at are pure numbers; you would see asset classes that go up in a steady and seductive line until they experience horrific drawdowns. Asset classes like credit, value investing, and carry trades. And then you would see asset classes where there are negative to flat returns with huge profit jumps and convexity. Those would be asset classes like global macro investing and, if done correctly, trend-following CTAs and long- volatility/ tail risk managers.

To prove this point we took a cross section of hedge fund returns using HRFX indices. These are some of the most popular hedge fund strategies. And we looked at that versus a rolling put option on the S&P 500, a simplistic strategy of selling a put and rolling that forward. The results showed that this cross-section of traditional hedge fund strategies has a very large correlation, and rising correlation to a simple short volatility strategy of selling a put option. So whether you are a long-short equity manager, a value investor, or any other type of investor, most of your alpha has been derived from the equivalent of a volatility short. You think you are a good investor and you have this diversified mix of asset classes. This is wonderful, it is supposed to provide diversification in the event of a crisis. But in the crisis your portfolio is revealed for what it is, a portfolio that is comprised 98% of short volatility and 2% long volatility.

There are two types of institutions in this world: there are institutions that are short volatility and institutions that are massively short volatility.

If I had 100,000 dollars to invest and I went to a financial advisor in Austin, Texas, I’d ask “what should I do with my money?” And the financial advisor would say you should put that in a 60-40 stock bond split. Great, no problem. So I put that money in a 60-40 stock bond split, supposedly because there is anti-correlation between stocks and bonds. Now if I had 100 million dollars and I went to a more expensive financial advisor, they would say you should put your money in a 60-40 stock bond split, but you know what you should do – you should lever the bonds. That is called risk parity.

Well the entire global financial system is based on this anti-correlation between stocks and bonds. So I decided to run a correlation and see how often that relationship holds true. The negative correlation has only existed 11% of the time from the 1800s. It just so happens that most of that has occurred within the last 30 years. That is because most of that relationship is driven by the volatility of CPI.

30% of the time, stocks and bonds actually will have a positive correlation to one another. That means the “taper tantrum” could just be the beginning of something more. So, many times across history your 60-40 stock bond split becomes a 100% loser. And in those scenarios volatility is the only asset class that you should really be looking at to save you. Most people are now looking at selling volatility as a yield alternative rather than considering it as a way to protect themselves.

So what will be the outcome of this economic Prisoner’s Dilemma? I can think of five potential outcomes:

i. Global cooperation between central banks and growth results in currency war disarmament. It is possible. I doubt it.

ii. Class war followed by political revolution. This is very scary. The US has the greatest levels of income disparity since 1928. Real income for families in the 20th percentile of earners has essentially stayed stagnant since the 1970s. This class warfare and the anger that results from this will spill over into political risk, we are already beginning to see that in Greece.

iii. Global war. I think it is interesting that people downplay the effect that World War II had on the deleveraging process and the resolution of the problems of the Great Depression. For those of you who think of global war as impossible, I suggest you look at parallels between 2014 and 1914.

iv. Sovereign default. I love it when academics say that the default of a developed sovereign nation is impossible because central banks can just print money and buy their own debt. To me that is like saying my house will never be burgled because if someone breaks in I can just light it on fire. The next Lehman Brothers may very well be a country.

v. A good old fashioned hyper asset bubble followed by collapse.

So how do you get out of the Prisoner’s Dilemma – how do you escape this Alcatraz of currency debasement, QE, and ZIRP? I get it, you need to own beta (simple equity or credit exposure). But you also have to combine that beta with smart volatility exposure on both the left and the right side of the return distribution. If you do that you are protected against the excesses of the Prisoner’s Dilemma. Thisis why volatility will be one of the most important asset classes for the next two decades.

So volatility is no different in markets than it is to life. It is an instrument of truth, and regardless of how it is measured, it just reflects the difference between the world as we imagine it to be and the world that actually exists. We are only going to prosper if we relentlessly search for the truth. Otherwise the truth will come to us through volatility. The world has gone mad, and the truth is coming. Thank you.