“Volatility is an instrument of truth,” proclaims Artemis Capital’s Chris Cole in a wide-ranging interview with The New York Times, warning that “the more you deny the truth, the more the truth will find you through volatility.“
In 2012, Artemis Capital’s founder wrote one of the most profound letters on volatility regimes in the new normal, tying together defaltion, hyperinflation, and the alchemy of risk, and now he is concerned that markets are too focused on short-term volatility and is betting that a spike in volatility is on the verge of rattling the stock market.
“Optically, volatility is still very low, but fear is increasing,” Mr. Cole said, pulling up a chart on one of his six trading windows. It showed that in the months beyond the 30-day period measured by the Chicago Board Options Exchange’s VIX index, investors were expecting some violent moves to come in the stock market.
As The New York Times reports, Cole argues that this market calm cannot last.
In doing so, he draws parallels to the stock market crash of 1987, when investors were similarly lulled into believing that volatility would not erupt. Now, as the 30th anniversary of Black Monday looms, when the S&P plunged 20 percent, Mr. Cole is wagering on a similar calamity, underpinned by a vicious spike in the VIX and a steep sell-off in stocks.
“The fact that everyone has been incentivized to be short volatility has set up this reflexive stability – a false peace,” he said.
“But if we have some sort of shock to the system, all these self-reflexive elements reverse in the other direction and become destabilizing as opposed to stabilizing.”
At the moment, Mr. Cole calculates that as much as $1.5 trillion in investor money is betting the markets will remain as they more or less have been since 2009: volatility free.
This sum, he says, includes about $60 billion in funds that are explicitly short volatility in its many forms. The bulk of this amount is in funds that deploy strategies where volatility is a critical input for allocating exposure to the stock market. So the lower volatility is, the more these funds load up on stocks. In 1987, portfolio insurance transformed a market decline into a historic rout when computer driven programs sold stock market futures into a panicked marketplace absent of willing buyers. Mr. Cole says this $1.5 trillion in short volatility money can play a similar role today if the fear gauge index spikes sharply.
As he sees it, the formulaic strategies that sold stock market futures into a falling market in 1987 and the short volatility money of today are akin to barrels of petroleum that can turn a mere fire into a seismic conflagration.
“In 1987, we were in a bull market, and the Fed was behind the curve with regard to inflation and interest rates,” Mr. Cole said.
“What could cause a crisis now is if rates suddenly spike higher, share buybacks seize up and then the volatility sellers turn into volatility buyers all at once.”
It is, in many ways, a moral argument for him…
“Volatility is an instrument of truth, and the more you deny the truth, the more the truth will find you through volatility,” Mr. Cole said.
“If central banks want to keep saving the day, that is fine. But volatility will then be transmuted through other forms like populism and identity politics and threaten the fabric of democracy. And that is something that my hedge fund will never be able to protect against.”
Ultimately, Cole believes that those who have held volatility in abeyance for so long — from risk parity funds to global central banks – will face a reckoning.