I feel as sure as one can be about an entirely unknowable outcome that soon something spectacular is going to start. It could all be an anti-climax, but I think there’s a strong case to be made for it.
In this piece I am going to explain why I think we could be heading into the most spectacular swing in decades and also how this would seem to be time when it could be possible to have the highest probability of successfully forecasting something spectacular. How we can build a case for it and not just be guessing.
The Bursting of the Short Volatility Bubble
During the rally from the 2008 low to the 2018 high a short record lows in volatility were hit.
The uptrend not only didn’t have big pullbacks it also was progressing slowly. Volatility was really low and this led to funds being set up that were based on short volatility strategies. And in Feb 2018, these got hammered. Short vol funds who’d had stable gains for years jus wiped out in a day.
If you’d like to read a breakdown of what all happened, see: Volmageddon and the Failure of Short Volatility Products by Patrick Augustin, Ing-Haw Cheng, Ludovic Van den Bergen :: SSRN
But what all happened isn’t important to my point. It happened and when it happened the short vol bubble burst. From record lows in vol we seen big increases. It was not the case that the 2018 market dropped but went back into the slow stable climb like out of 2015 or 2008. Move up were also faster than previously.
And that continued … Big time!
No one told the VIX, but we’ve been in an expansion of volatility since 2018. Every year since 2018 something more wild than the last has happened. In 2019 I thought I was seeing late stage mania. In 2021 I laughed at how naive I had been in 2019. There wasn’t even billboards in 2019.
Volatility is mean reverting. Which means, hitting record lows and the sharp reversal of that might have marked the end of that extreme in vol. Vol is now reverting to the mean and in mean reversion the mean is usually overshot before finally later it does come back to settle for a while around the mean.
So we’re in a volatility expansion. If we take this mean reversion thesis of vol we can expect to see increasingly dramatic swings in the market until something absolutely massive happened and then markets go into some sort slow grind or prolonged range. If vol is mean reverting and we came off record lows it make sense vol will increase.
The bursting of the vol bubble would imply we’ll have more volatile markets for at least a decade after the bursting of it. We’d still have five years of expanding vol and we’d be years away from the crescendo.
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