Volatility Compression and the Federal Reserve: Dulling the Market’s Price Discovery Mechanism

Hedge funds have been struggling recently. According to CNBC, hedge fund outflows reached $60 billion in June, with the rate of withdrawals increasing. Although the average American might not feel much sympathy for the typical hedge fund manager, the struggling hedge fund industry points to a real problem in the financial sector: the Federal Reserve’s suppression of overall volatility and the corresponding suppression of inter-asset volatility. When overall volatility (in the sense of the S&P moving up or down) is suppressed, inter-asset differentiation is also suppressed.

This should make intuitive sense – if there is a giant influx of new credit, all asset prices go up and so the relative change in price is attenuated. The relative change in price between different assets (hereafter referred to as inter-asset differentiation or inter-asset volatility) is also therefore less. The current popularity of index funds and the corresponding contemporary distaste for hedge funds both reflect this point.

Basically, because newly-printed money has to go somewhere, it distinguishes less between assets (compared to what it would have relative to the old price). By inflating assets prices basically all across the board, central bank easing has dulled the market’s price discovery mechanism.

Warren Buffet’s famous quote “Only when the tide goes out do you discover who’s been swimming naked” reflects this point well –when there is an influx of credit the markets perception of corporate value is distorted and its ability to differentiate is dulled – only when the credit cycle reverses does the market regain its ability to differentiate. When the “tide goes out” there is credit scarcity and the opposite logic applies: volatility and inter-asset differentiation spike.

Think of this effect mathematically: consider asset A and the universe of stocks with which it is compared. Both appreciate at an extra 1 percent a day because of a new influx of credit. This example expresses the process of credit expansion: since the influx of new money is gradual, valuations increase not automatically but over time as credit expansion settles its way into the market.

Theoretically, therefore, the best representation of undiscriminating credit inflows is a smooth curve. The hypothetical 1 percent move is a first derivative of that curve and can be applied to any timeframe, as long as it is continuous. The same theory can also be generalized to illustrate the entire process of credit expansion, no matter what the actual rate of that expansion is. On a day in which an asset A would have declined by 1 percent and the index risen by the same rate, asset A would now not move and the index would increase by 2 percent. Asset A’s performance is now more similar to the market’s.

The same effect happens even if the numbers are different: if asset A appreciates 2 percent and the market 3 percent, now it would be 3 percent and 4 percent, and instead of moving two-thirds of what the market moved it now would move three-fourths. The result is that the stock tracks the market more closely, and the distribution of betas is compressed. For a hypothetical market with a normal distribution of returns, graphically the effect looks like this:


Note that the overall market returns have increased, and that the distribution of betas has compressed. Returns, while increasing, cluster more closely around the market average.

A further point is that the mechanism is self-reinforcing: because assets are rising in price, the perception of relative risk (Beta, Sharpe ratio, etc.) diminishes and newly-created money is therefore more likely to flow to those artificially less risky assets, further diminishing their perceived risk and further degrading the market’s ability to differentiate.

The result is that inter-asset volatility goes down further. This effect is particularly pronounced with risk metrics like the Sharpe ratio that give greater weight to negative movements than positive ones. Across the board credit expansion impacts these ratios more severely because the relative reduction in negative movements is larger compared to the increase in positive ones. For example, a shift from 1.5 percent to -.5 percent is a much larger relative change than 1.5 percent to 2.5 percent.

Index funds are both a reflection of and reason for this trend. Index funds do not distinguish between different stocks in an index when they buy stocks – they buy a little bit of each company proportional to its size. The same logic applies as with credit expansion above: such indiscriminate buying compresses the beta distribution of all the stocks within an index. Index funds are also more profitable if inter-stock volatility is down because it is less profitable to distinguish between stocks.

What does this mean for portfolio allocations? The implication of the argument is that the market cannot distinguish as well between risky and non-risky assets during credit expansions. Therefore, returns during expansions are not as accurately risk-adjusted and so absolute returns are more similar across disparate-risk assets. Risk has been mispriced and over-bid. One should therefore decrease risk in one’s portfolio and buy assets that perform especially well when the “tide goes out.” Because of the smaller performance difference between disparate-risk assets, this should not affect returns as much if the expansion continues.

One might also want to rebalance the portfolio to include more cash, precious metals, and corporate securities with very strong balance sheets. These assets are mostly ones that perform well during periods of high overall volatility. When the market underperforms and investors rush to reduce their exposure to risk, these assets will appreciate in relative terms and perhaps even relative to cash (e.g. gold). If credit expansion continues, portfolios should not be affected as much because the rising tide will still “lift all boats” and less-risky assets should be among that tide. In any case, to paraphrase Warren Buffet, don’t get caught swimming naked when the tide goes out.