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Crisis Alpha

Traders Magazine Online News, February 1, 2018

Damian Handzy

WHAT GOES UP… How long can it go on? The bull run since the depths of the global financial crisis has seen the S&P grow from a low of 682 to a recent high of 2742, a staggering 17% CAGR over nine years. Just this morning the Dow topped 26,000 for the first time. Other markets have also exhibited surprising behavior: worldwide yields – initially driven down by central bank intervention – have remained low, oil has largely maintained its post2014 collapse levels, and virtually all markets have seen a dramatic drop in volatility. Investors’ insatiable search for the stability of dividend-like returns has driven volatility out of nearly every financial market. In hindsight, it’s been an equity investor’s dream: rising equity prices, low-yields, low inflation and low volatility.

But today’s high – some might say exorbitant – equity valuations are a growing concern for investors. Last year’s US tax cuts have furthered bulls’ optimism, but recent rises in bond yields have cast a shadow on that exuberance. Historically, high equity prices have been supported by low-yields like the ones we’ve had over the past decade. Those days appear to be numbered. Equity investors have traditionally looked to bonds and cash for diversification, but if yields rise it would pose a double-whammy by eroding equity valuation support and simultaneously lowering bond prices.

Despite the turbulence in world politics, markets’ volatility was eerily low in 2017. While the S&P was up 19% last year, the VIX had its quietest year ever – turning long volatility plays into losses. Hedging has become a very expensive activity and fewer investors are bothering with paying for such protection. Recent CFTC data shows that more hedge funds hold short volatility positions than long volatility positions: a bet that can backfire spectacularly. With fewer funds holding equity hedges, when the inevitable down-turn comes, more funds will have no choice but to rush to sell their shares, thereby amplifying the volatility and a price plunge.

…DOESN’T HAVE TO COME DOWN AS HARD Enter the notion of ‘Crisis Alpha,’ the concept that some strategies are able to provide uncorrelated returns in normal markets and positive returns during market crashes. While many traditional managers count on bonds to provide this sort of hedge, as demonstrated in the classic ‘flight-to-quality’ maneuver during equity sell-offs, fixed income doesn’t often provide positive returns during such crises. The correlation between bonds and stocks, which on average is about zero, can oscillate in a matter of days between extremes of +0.8 and –0.8 according to our studies. What was put on as a strong hedge can quickly unravel into a doubling-down, providing a surprising sting to an unsuspecting investor.

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