These beliefs are good examples of well-known cognitive biases such as anchoring, confirmation bias and selective perception. Analysis tells us that there is little basis for complacency. Yet the VIX is back near all-time lows as shown in Chart 1 below.
Even if the probability of any one event blowing up is low, when you have a long list of volatile events, the probability of at least one blowing up approaches 100%.
With this litany of crises in mind, each ready to erupt into market turmoil, what are my predictive analytic models saying about the prospects for an increase in measures of market volatility in the months ahead?
They’re saying that investor complacency is overdone and market volatility is set to return with a vengeance. Even with the Facebook blowup and trouble in the tech space, VIX is just above 13.
Changes in VIX and other measures of market volatility do not occur in a smooth, linear way. The dynamic is much more likely to involve extreme spikes rather than gradual increases. This tendency toward extreme spikes is the result of dynamic short-covering that feeds on itself in a recursive manner — or what is commonly known as a feedback loop.
Shorting volatility indexes has been a very popular income-producing strategy for years. Traders sell put options on volatility indexes, collect the option premium as income, wait out the option expiration and profit at the option buyer’s expense. It’s been like selling flood protection in the desert; seems like easy money.
The problem is that every now and then a flash flood does hit the desert.
When we consider recent financial catastrophes affecting U.S. investors only, without regard to other types of disaster, we have had major stock market crashes or global liquidity crises in 1987, 1994, 1998, 2000 and 2008.
That’s five major drawdowns in 31 years, or an average of about once every six years. The last such event was 10 years ago. So the world is overdue for another crisis based on market history.
Investors expect that the future will resemble the past, that markets move in continuous ways and that extreme events occur rarely, if at all.
These assumptions are all false.
The future often diverges sharply from the recent past. Markets gap up or down, giving investors no opportunity to trade at intermediate prices. Extreme events occur with much greater frequency than standard models expect.
When they do strike seemingly from nowhere, like fire in a crowded theater, everybody panics and a wave of selling feeds upon itself.
The trouble is, most investors will never make it out of the theater in time.
- Source, James Rickards
