Investors are getting increasingly jittery as a new reality sets in. Since the global financial crisis, monetary policy has been the overriding factor moving market prices. The playbook for success in this one-dimensional era was "don't fight the Fed," a luxury that is now being taken away.
As central banks begin to step back other forces are stepping up, making markets more multidimensional. Other risks — geopolitical, trade, demographic — are starting to percolate. The risk environment is more diverse, forcing investors to think more deeply about where markets might head.
It's only natural that confidence in your solution drops when you're forced to adopt a new mindset, to contemplate myriad dimensions and forsake time-tested strategies that no longer work for exponentially more complex problems.
And when conviction ebbs, even the smallest piece of new information can create discomfort and usher in a significant response, leading to violent market moves. Crucially, this has nothing to do with increasing economic fragility; it simply reflects the jitteriness of investors' psyches.
This manifested itself most vividly on Feb. 5, when the CBOE's Volatility index of implied future volatility for the S&P 500 suddenly surged an unprecedented 20 points to 37 after averaging 11 in the prior 12 months. It was like a sudden, violent eruption of some long-dormant volcano that caught investors off-guard. Even in hindsight, it's difficult to identify exactly what the catalyst was for the move, which caused the Dow Jones industrial average to register its biggest intraday points decline and a 4.6% drop on the day, the largest since the European debt crisis in August 2011.
Not much had obviously changed in the data. Economic stability didn't give up, investors did. And ultimately, the VIX mean reverted as that moment of worry passed.
The lack of conviction was on display again on May 29 when Italian two-year bond yields climbed 1.86 percentage points after President Sergio Mattarella vetoed the appointment of a finance minister, throwing plans for a new coalition government temporarily awry. The contagion sent 10-year Treasury yields plummeting 15 basis points, the biggest one-day move since June 2016, as investors ran for cover.
Again, the reaction was out of proportion to the significance of the event, and the latest example might be Turkey. From Aug. 8 to Aug. 17, U.S. and Japanese equities had a wild ride, selling off and rebounding sharply on Turkish pain and fears of potential contagion. Over this period, the VIX also jumped by nearly 60%, only to fall just as precipitously soon after.
Such reactions are reminiscent of chaos theory's best-known tenet of a butterfly's wing flap in Africa triggering a tsunami in the Pacific. The butterfly effect is the notion that a small change in starting conditions can lead to grave differences in outcomes — the hallmark of instability.
On both global macroeconomic growth and company performance bases, such skittishness doesn't make sense, suggesting nervousness is increasing and will continue to do so as investors struggle to calculate the potential impact of an enlarged set of data inputs beyond central bank policy.
While that might present opportunities for those with enough conviction to filter noise and follow Warren Buffett's advice and jump in when there's blood on the streets, it also suggests that dips will have to become deeper before those with intestinal fortitude can be persuaded to take the plunge, as making sense of today's environment requires thinking beyond central bank activity.
As risk becomes more multifaceted and less about central bank support, assets have to stand on their own. Some will be able to do so and others won't, so that heterogeneity will again characterize markets. We now see this in options prices, which provide extremely efficient estimates of the market's assessment of upside potential through the pricing of call options and downside risk through the pricing of put options.
Options prices show a clear and substantial preference for the S&P 500 over all other equity regions. At the other extreme, they show a distinct aversion for European equities.
There is not only divergence in equity attractiveness geographically, there is also divergence in the uncertainty of outcomes across regions, with options pricing in much greater potential for stock volatility to rise in Europe vs. the U.S. The options market sees a much greater chance of the V2X index of implied future volatility for the Euro Stoxx 50 rising than falling compared with the VIX.
As more sources of risk assume increasing importance, investors will have to move further away from their reliance on single-factor calculations based on monetary policy and further toward broader, more creative analysis. The level of thinking that will yield success will be much more demanding.
Learning to let go of their reliance on central bank policy as the driver of behavior and embracing a new and far more complex paradigm is a process fraught with multiple, unfamiliar risks, suggesting that investors might continue to lack conviction as they grapple with a return to this old normal.
In such turbulent times, butterflies will dominate.