Volatility Insurance

In Texas everything is bigger including the dry-aged beef ribs at Hubbell & Hudson in the Woodlands and the lazy river at Houston’s Marriott Marquis, shaped familiarly.

We were visiting clients and friends before quarterly reporting begins again. Speaking of which, ever been surprised by how stocks behave with results?

We see in the data that often the cause isn’t owners of assets – holders of stocks – but providers of insurance. To guard against the chance of surprises, investors and traders use insurance, generally in the form of derivatives, like options. 

Played Monopoly, the board game? A Get Out of Jail Free card is a right but not an obligation to do something in the future that depends on an outcome, in this case landing on the “go to jail” space. It’s only valuable if that event occurs. It’s a derivatives contract.

At earnings, if you shift the focus from growth – topline – to value – managing what’s between the topline and the bottom line – the worth of future growth can evaporate even if investors don’t sell a share.

Investors with portfolio insurance use their Get Out of Jail Free cards, perhaps comprised of S&P 500 index futures. The insurance provider, a bank or fund, delivers futures and offsets its exposure by selling and shorting your shares. It can drop your price 10-20%.

Writers Chris Whittall and Jon Sindreu last Friday in the Wall Street Journal offered the most compelling piece (may require registration — send me a note if you can’t read it) I’ve seen on this concept of insurance in stocks.

Investors of all ilks, not just hedge funds, protect assets against the unknown, as we all do. We buy life, auto, health, home insurance.  We seek a Get Out of Jail Free card for ourselves and our actions.

In stocks, we track this propensity as Risk Management, one of the four key behaviors setting market prices. It’s real and by our measures north of 13% of total market cap.

But the market has been a flat sea.  No volatility.  This despite a new President, geopolitical intrigue, global acts of terror, a Federal Reserve stretching after eight Rumpelstiltskin years, and a chasm between markets and fundamentals.

Whittall and Sindreu theorize that opposing actions between buyers and sellers of insurance explains the strange placidity in markets where the VIX, the so-called Fear Gauge derived from prices of options on stocks, has been near record lows.

The thinking goes that the process of buying and selling insurance is itself the explanation for absence of froth. Because markets seem inured to threats, investors stop buying insurance such as put options against surprise moves, and instead look to sell insurance to generate a fee. They write puts or calls, which generate cash returns.

Banks take the other side of the trade because that’s what banks do. They’re now betting volatility will rise. To offset the risk they’re wrong, they buy the underlying: stocks. If volatility rises the bet pays, but the bank loses on the shares, which fall. 

This combination of events, it’s supposed, is contributing to imperturbable markets. Everything nets to zero except the stock-purchases by banks and cash returns generated by investors selling insurance, so there’s no volatility and markets tend to rise.

Except that’s not investment. It’s trafficking in get-out-of-jail-free cards.

And despite low volatility, there’s a cost. We’ve long said there will be a Lehman moment for a market dominated by Risk Management.

We’ve seen hedge funds struggle. They’re big players in the insurance game. And banks have labored at trading. Maybe it’s due to insurance losses. Think Credit Suisse, Deutsche Bank, HSBC.  Someone else?

From Nov 9-Mar 1 the behavior we call Risk Management led as price-setter marketwide, followed closely by Active Investment. The combination points to what’s been described: One party selling insurance on risk, another buying it, and a continual truing up of wins and losses.  

Now, for perspective, the VIX is a lousy alarm system. It tells us only what’s occurred. And intraday volatility, the spread between daily high and low prices across the market, is 2.2%, far higher than closing prices imply.

We may reach a day where banks stop buying insurance from selling investors, if indeed that’s what’s been occurring.  Stocks will cease rising.  Investors will want to buy insurance but the banks won’t sell it.  Then real assets, not insurance, will be sold.

It’s why we track Risk Management as a market demographic, and you should too.  You can’t prevent risk. But you can see it change.