Wednesday, September 19, 2018

Volatility Mavens Artemis Capital Management | Letter to Investors | July 2018

Always interesting, even a couple months out of date.
From Chris Cole's Artemis Capital:

What is Water in Markets? Volatility and the Fragility of the Medium
“This is Water” is the title of a commencement speech delivered by David Foster Wallace that has become a masterpiece of meta -thinking. If you haven’t listened to it, put down this paper and do so now. It is worth 20 minutes of your life. The Foster Wallace parable of two young fish ignorant of the medium that defines their reality is so important on many levels. Foster Wallace contends that we swim in a world defined by self-centered thoughts, that serve to make reality visible, but should never be mistaken as fundamental truth.

In capitalism the medium that defines reality is fiat money. To this point, does money exist? This seems silly to ask but it is very important philosophically. Yes, money exists in the sense that you can purchase goods and services with it. At the same time, money is only important because of a collective belief in it, and is worthless without that. This is true of any human construct: markets, words, brands, and nation-states... all abstract mediums that have meaning because we collectively believe they do, and hence they give form to reality, but are not real independent of our thoughts.

In markets and in life, we swim in mediums of thought abstractions... the same way a fish swims in water . When the medium collapses, so does the reality... causing us to question the nature of both. As Foster Wallace eloquently explains, “ The immediate point of the fish story is that the most obvious, ubiquitous, important realities are often the ones that are the hardest to see and talk about.”

Volatility is always the failure of medium ... the crumpling of a reality we thought we knew to a new truth. It is the moment whe re we learn that we are a fish living in a false reality called water... and that reality can change... or there are other realities. True volatility isn’t the change of the thing, it’s the changing of the medium around it and the realization that the thing never really existed in the first place.

This is all you need to know to understand when the volatility storm will truly come. It is not about valuations, money printing, or where the VIX is at any point. When the collective consciousness stops believing growth can be created by money and debt expansion the entire medium will fall apart violently, otherwise it will continue to be real. The belief that the medium is the reality is what holds the edifice together temporally.

This letter is divided into three key themes: The first part will discuss fragility of the market medium; the second will discuss how the volatility in February was a symptom of a much greater liquidity problem ; and the third will discuss how flows are more important than fundamentals when the medium dominates truth. Out of the fishbowl and down the drain we go...

Fragility in the Medium 
Investors swim in a pond of bid and ask prices. Without a bid and ask there is no price discovery... and the market... like a fish out of water... dies . Now here is an interesting question: does the market create value, or can value exist without a medium to facilitate it? A silent revolution is now being fought for the soul of investing between two contradictory schools of meta -thinking, each with their own strategies and central planning philosophies to support them. These two schools are the following:

1) Value is independent of the medium and intrinsic to the asset: The classic school of investing embodies the value investing principals of Graham and Dodd as put into practice by investors like Warren Buffet (younger version) , Seth Klarman, and David Einhorn. In this school, the bid and ask prices of an asset do not represent value any more than a picture of a “pipe” is a real pipe. Liquidity is a highly flawed medium to express value. Although prices may fluctuate they are independent from the intrinsic worth of an asset . If you want to smoke a pipe, the picture is not sufficient to provide value.

2) Value is generated from the medium . In the second school, liquidity is the sole determinant of value as defined by a constant bid and ask price. An asset is only worth what someone is willing to pay for it at any given moment. If Facebook, Snapchat, Tesla, Ethereum, and Ripple keep going up, who cares why, as long as someone is willing to pay. When market participants gain confidence in a quantitative investment factor (growth, low volatility, cat ownership of company management), it becomes real, regardless of whether it makes sense. As long as people supply a bid and ask price, the medium is the reality, so to speak. The school is also supported by modern central banking policies. If a picture of a pipe looks like a pipe, it is a damn pipe, especially if people buy more tobacco.

The second meta-view of value is now winning the revolution and dominating central banking and institutional asset flows. Passive and factor -based investments are just the most obvious symptom of this new worldview. If value is “created” by the medium of money, you don’t need to pay people to find it, hence active investors should be replaced by passive index funds, systematic trading, and factor -based quantitative investments. Today fundamental discretionary traders only account for 10% of trading volume in stocks according to J .P . Morgan, while rules-based strategies account for 60%. Since the recession $2 trillion in assets have migrated from active to passive strategies. Starting this year, over 50% of the assets under management in the U .S. will be passively managed according to Bernstein Research . Almost a decade of unprecedented global monetary stimulus resulted in the best risk-adjusted returns for passive investing in over 200 years between 2012 and 2017. Large capital flows into stocks occur for no reason other than the fact that they are highly liquid members of an index, and those capital flows chase the hottest ETFs and collections of stocks (FANGs)....

...MUCH MORE (11 page PDF)

Previous visits to Artemis:
October 2017 
"Will Short Volatility Trigger the Next Black Monday?"
 August 2017
"Volatility and the Prisoners Dilemma"—CBOE Risk Management Conference Asia, December 1, 2015

And many more, use the search blog box keywords 'Cole, Artemis' if interested.
(just using 'Artemis' will get you a hundred posts on reinsurance and cat bonds, worthy but not related, directly)

Baby Got Black (Swan)
(With apologies to Sir Mix-a-Lot)
I like… fat… tails and I cannot lie
You vol sellers can’t deny
When a hot trend breaks with a well-timed stop
and a great big black swan pop you get
Paid… P&L year gets made
‘Cause you noticed that trade was packed
Buncha mean reversion suckers got jacked

Oh baby I wanna get lumpy
Long gamma for when it gets bumpy
Central banks tried to haze me,
But those carry trades just don’t faze me!...MORE
Genius or madman?

It should be noted that we were introduced to Mr. Cole by FT Alphaville.
From the intro to May 2017's "VIX Surge Is Unwelcome Lesson in Duplicity of Volatility Wagers"--UPDATED:
FT Alphaville's Izabella Kaminska used to talk with Chris Cole of Artemis Capital about volatility but I haven't seen him mentioned in a while. What he's up to is on a whole different level from the usual. Here's an example: The shadow convexity risk in the machine (and the VIX)
Or 2014's "An Awful Lot of People Are Shorting Volatility (VIX; VXX; XVIX; XXV)":
I'm starting to wonder if Izabella likes posting on volatility because, in addition to talking to Chris Cole who is pretty sharp, the ETP symbols read like Roman numerals?

As to the headline, I mean "awful lot" in both the colloquial and the literal....
But, instead of listing our links to FTAV, you can go directly to the source:
site: Chris Cole