May 14. The Litmus Configuration

It was back in 2003 that Jonathan Mardukas (then at Lehman) first postulated his Litmus Configuration Theory. Recall, this was after the dotcom bubble had burst and followed 9/11. The theory states that too much Central Bank interference can result in markets that exhibit extremely low volatility. He named it after the Litmus test because markets would not go down (litmus paper turns red, or acidic) and also failed to rally (blue, base).  His work is often misattributed to Alonzo Mosely, whose pioneering work on money supply showed that excess reserves can often take on the same characteristics of counterfeit bills when ‘currency in circulation’ is the Primary medium of exchange. (1)

We all like a good story as an explanation of why markets behave as they do. I was struck this week by just how many ‘big thinkers’ (no, Donald isn’t in this particular group) have weighed in on the topic of low vol. On Google Trends, when I typed in VIX, I thought the results might show a huge jump, given all the talk about near historic lows in the index. The chart did show that interest in the search was near a recent high, but the results weren’t dramatic. “Volatility Index” showed a similar result. It’s at a new high for the year, but below last September.

So who are the big thinkers? First, Ray Dalio, in a new post on Linked In, tacitly embraces the Bullard ‘steady state’ thesis: “The major economies right now are in the middle of their short term debt cycles and growth rates are about average. …As a result, volatility is low now, as it typically is during such times. Regarding this cycle, we don’t see any classic storm clouds on the horizon.” However, he goes on to cite longer term issues in the form of debt and non-debt obligations like pensions and entitlements, and concludes: “So we fear that whatever the magnitude of the downturn that eventually comes, whenever it eventually comes, it will likely produce much greater social and political conflict than currently exists.”

Ben Hunt of Epsilon Theory frames the issue in this way:  “…the one Big Question: as the Western status quo political system collapses into Something Else, how is it possible that our capital markets are not similarly gripped by volatility and stress? What is responsible for breaking the transmission mechanism from political risk to market risk?” 

While I love Ben Hunt’s writing, he summarizes the situation (in his first ‘macro’ section) as others have previously. “In the absence of an active and effective fiscal policy authority, global monetary authorities will fill the policy void.” [Leading to] Low growth. Financial asset inflation and Low Volatility.

He concludes: “That’s my macro story for the divorce of political risk from market risk, and I’m sticking to it. Where does it break down? Not with a funky German or Italian election, but with Janet and Mario declaring victory and taking away the punchbowl. That’s what will bring political risk back to markets.”

Doug Noland of the Credit Bubble Bulletin summarizes: “There’s a major Reflexivity component at work. Cheap market “insurance” spurs risk-taking. Why not push the envelope with risk and employ added leverage, confident that inexpensive protection is readily available? This ensures that loose financial conditions spur Credit expansion, asset inflation, spending, corporate profits, rising incomes and government receipts/spending. Perceived wealth inflates tremendously, if not equitably. Rising price levels throughout the economy support the view that the future is bright, encouraging reinforcing flows into financial assets – further depressing the price of market “insurance.” Moreover, a prolonged period of low market yields boosts the relative return appeal of myriad variations of writing market protection (selling flood insurance during a drought).” [Hey, this guy ought to be on the Fed board].

Lloyd Blankfein put it this way (in contrast to Ray Dalio). “I don’t know what brings us out of the doldrums, but I do know this is not a normal resting state.” He further mentioned we might be in a “bubble of confidence.”

And so we have this phenomenon of low volatility across markets. We have people scratching their heads over it. How does the central bank view it? Well, I am not going to claim that Philadelphia Fed President Harker speaks for the Fed, and he certainly contradicted a couple of other Fed officials who have suggested putting balance sheet reduction on auto-pilot, but here’s a quote from Harker that sort of crystallizes the Fed’s paralysis regarding market reaction (from Reuters):

“We can slow the pace of that or accelerate the pace of that depending on how the market reacts,”

“We just have to be cautious and very clear in our communication,” [Harker] added. If “we are willing to adjust if things change, we can minimize disruption to the markets, and that’s exactly the plan.”


Look, as a situation unfolds, people in general CREATE a narrative as an explanatory tool. Often, these narratives violate causation versus correlation and tilt dangerously close to the edge of superstition, while falsely citing fantasy academic studies. The latest narrative concerns indexing and passive investing. I sure as heck am not going to dismiss it, but I think it’s more of a symptom than a cause.

The argument goes this way: In a world of a sub 2.5% ten year note, and spotty hedge fund and other ‘active investor’ strategies, it doesn’t make any sense to pay high management fees. No one can time the market so it’s much better to just find a low fee index fund. This investing style dampens volatility.

Hey, it’s a reasonable story. In the same way that UBER is a reasonable story. Don’t pay the high taxi fare that comes with the medallion and insurance. Use GPS and private drivers. It’s actually a GREAT idea. Now I don’t drive that much, but I was stuck in Chicago city traffic last Wednesday afternoon, (and I mean stuck, in a low movement, low vol position), and I noticed that all the cars around me had back seat passengers. My personal narrative is that UBER is slowing down traffic significantly. There are advantages to being a first mover, a certain excitement with the new thing, but then it starts to morph back into the old pattern…maybe that’s where we are now with fiscal policy.

Anyway, regarding indexing, there was this article: There Are Now More Market Indexes Than Stocks

A further separation of the underlying asset, a discounted stream of future earnings of a company, to an ‘investing vehicle’ that likely has a larger influence on the price of the underlying than actual earnings. Wag the dog.

Finally, on the topic of indexing, I have these two quotes. First from Jack Bogle, “If everybody indexed, the only word you could use is chaos, catastrophe.”  Hey Jack, that’s TWO words.  [From Midnight Run: ‘Jack you’re a grown man, you have control of your own words.’… ‘Here come two words for you’…]

The second quote comes from the FT. “Short term asset price declines have been reversed by the wall of money coming out of active investment managers and into the accounts of low-cost index products. But this comes at the expense of making the eventual decline in a broad range of asset values not just painful, but catastrophic.”

Now that I’ve looped myself into a stream of Midnight Run clips, I’ll summarize with the litmus configuration. We don’t know whether or not the money out there (and the pyramid of assets that rest upon it), is fake or real. We have a low vol environment that Dalio seems to suggest will unravel under its own weight. Ben Hunt thinks it will happen due to Central Bank mistake. I think the catalyst may come from Asia, or, as Trump refers to it, Jina. Or maybe the catalyst will be some sort of giant ransomware attack. Nah… Can’t happen.

(1) I am making this up. And Midnight Run is from 1988.

Posted on May 14, 2017 at 12:40 pm by alexmanzara · Permalink
In: Eurodollar Options

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