By Lily Kane
Across the world, Vanderbilt Business alumni find themselves on different frontlines of the COVID-19 pandemic. In this installment of COVID-19 Insights, Eric Noll, Chief Executive Officer of Context Capital Partners, discusses market volatility and what it means for larger market conditions.
Editor’s note: This interview was conducted on June 12.
What is market volatility, and what factors drive it?
Market volatility is a result of variance of stock or asset prices. In times of low volatility, they vary little. During times of high volatility, they vary tremendously. What drives market volatility is uncertainty. The value of an asset is essentially the value of its future cash flows, or rather what market participants agree on the value of those future cash flows. When there are market shocks, the uncertainty about what those cash flows look like expands massively, their worth is re-valued, and prices have a wider deviation and spread from where they were.
How does volatility impact market operations (liquidity, investor actions, regulations, etc.)?
Under normal circumstances, a stock like Apple, say, may trade in a bid/offer spread as little as 10 cents or lower — this bid/offer spread is the cost that market participants assess will provide liquidity to Apple. In times of volatility, the bid/offer spread widens dramatically, rewarding market participants for uncertainty and risk. That bid/offer also gets thinner in size, so that market participants can additionally mitigate risk. This compounds volatility and impacts market operations. If I’m in a large institutional investment and I need to move shares, my cost is higher but the size is thinner, so I get less done. Also, volatility begets volatility when everyone wants to go the same way at the same time. For instance, if everyone moves to the sell side, there’s less liquidity on the bid side. This can become a freight train going in one direction, which can trigger circuit breakers in the market. In the beginning of the COVID-19 pandemic, circuit breakers were triggered often, halting the market and giving everyone time to breathe, reassess, and re-open at what was agreed to be a fairer value. This ultimately worked, in the sense that it allowed the markets to continue to operate and function.
Hedge funds are designed to be long/short, providing an alpha return while balancing upside and downside appropriately. So, they should do better in uncertain times. However, because we have had a long bull market with such little volatility over the last decade, in order to generate returns, a lot of hedge funds moved away from truly being hedge funds. There were and are classes of hedge funds that were managing systematic macro investments — very computer- and algorithm-driven — that did very well. Tail-risk hedge funds with long, big market moves do well. So, there’s a class stratification in hedge fund performance where there are clear winners and losers.
What does volatility forecast for larger economic conditions?
Because volatility is a measure of uncertainty, you see the terms and structure to suggest this will continue for some time. If I’m looking to deploy capital or reinvest, the uncertainty has grown, in some cases exponentially. So, investors may invest less or invest in less risky assets, such as gold and treasuries. Interestingly, because this crisis is unique, you haven’t seen as much investment in real estate. Also, you could argue that bitcoin is similar to gold, in that it is a place where you could invest to store value while the world re-valued itself, but initially bitcoin went down (though it has recovered), so that remains to be seen.
What can be learned in this moment?
Broadly, what we can learn is that when markets develop a sense of complacency during a period of low volatility, a shock to the system causes massive disruption and loss. Therefore, even when it seems counter-intuitive, you should always manage your portfolio with a sense that this, too, cannot last.
When people say, “this is a new paradigm,” it tips me off that something huge is happening. You heard it during the internet boom, then in the late 2000s in real estate, and a few years ago, because there was no inflation and asset prices continued to rise. I’m not saying anyone predicted COVID-19, but rather that you know from history that there are shocks, and you should prepare your portfolio to expect them.
From an institutional investor side, a phenomenon we saw is that allocators of funds — endowments, pensions, etc. — took a hit in March. But interestingly, an outcome of this volatility is that assets are moving around. People are looking at where they did have investments, and where they should have had investments, and are making changes. In 2008-09, people hid under the mattress and hoped it would go away. Now, we recognize that this will end, and we want to be in the right place when it does.
What do the S&P, Nasdaq, and Dow tell us?
Markets are generally a future indicator for the real economy by about 6 months to a year. I think that what the market was saying — until June 11, at least — was that recovery is around the corner. On June 11, it indicated that economic recovery is coming, but it might not be quite as fast. The Dow is relatively unchanged since March; Nasdaq recently set a record. The economy is recovering, and I think relatively expeditiously.
Is this a Fed-driven rally?
I want to be careful in talking about how the Fed is propping up the market. What they’re really saying is, we’re going to take some actions to ensure that markets work. They need markets to function. During 2008-09, the market was broken because the mechanism of how risk was transferred and moved around the system no longer functioned. Now, the Fed is keeping banks primed for funding by keeping interest rates low, so that people who need to sell can sell, people who need to buy can buy, and the market will keep operating.
Ben Bernanke was a scholar of the Great Depression and operated with the understanding that, when the economy starts to collapse, you can’t restrict liquidity, you have to fund markets. Since we did recover, you can argue that he did a good job. Jerome Powell learned that markets can’t freeze, though. The gears have to continue to work.