Don Draper Buys Protection

Best headline of the week goes to Bloomberg’s Michael Regan – Everyone’s Don Draper Now as Volatility Nostalgia Sweeps Markets.

According to Regan, “Many on Wall Street are sounding a lot like Madison Avenue’s Don Draper these days, nostalgic for the not-so-long-ago wounds to markets that created profitable opportunities.”

Per The Don, “In Greek, nostalgia literally means pain from an old wound.”  While our own wounds have long since healed, we are still left with potent memories which continue to guide our decision making today.  My impression, though, is that these memories have been long forgotten by the consensus, evidenced by new all times in margin debt, increasing corporate leverage and near-record lows in volatility. As J.K. Galbraith lamented:

“In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by an always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”

Low volatility is once again incentivizing a rapid accumulation of leverage. We’ve read several reports in just the past few weeks highlighting the continuation of the so-called “Great Moderation” – as if this was a good thing!  According to one analyst, investors have nothing to worry about as “monetary policy remains as competent, if not more so, than it was in the pre-crisis period.”  If that doesn’t make you sleep better at night, try an Old Fashioned perhaps.

It would seem that the consensus has once again been lulled into complacency by the sweet sirens of Wall Street strategists who suggest that, “So long as a gradual economic recovery continues as we expect, so should the current low-vol environment.”

We’ve heard others actually claim that, “The aggressive re-regulation of markets has made us less vulnerable to Minsky Dynamics today than in the past.”  And consequently, “these factors will likely extend the stability and sustainability of this cycle relative to past cycles.”  For our part, we are left wondering exactly what “aggressive regulation” has eliminated risk from the system so effectively.

Today’s low volatility is not just a US phenomenon.  It’s not just an equity phenomenon either.  It is a global phenomenon across virtually all asset classes.  While the street may take comfort in the claim that low market volatility is the norm at this point in the business cycle given current economic conditions, we wonder if anyone has considered what happens if when current conditions change.

Plugging consensus forecasts into models might suggest that there is a good chance that the current low-vol regime will persist for some time.  We just hope that they are not the same models used by the same banks to forecast housing prices and/or their own balance sheet risk last time around.

Rather than rely on forecasts that extrapolate the present into the future, prudent allocators of capital would be better served to consider the alternative. Technically speaking, shit just happens every once in a while.

The fact that volatility is near all time lows today suggests that there is less room for it to move lower and a very long runway to move higher.  History would suggest that “random” shocks occur more or less regularly over time.  In our own experience, I have yet to see one “forecasted” by an economic model in advance.

So while low volatility may be consistent with current economic conditions, it would be wise to consider that conditions have, can, and will change.  That doesn’t mean there are not opportunities to make money in this market (there are and we’ll share a recent idea in our next post).  It just means that sticking your head in the sand and pretending that goldilocks will stick around forever – after crawling back into bed with financial markets – is setting folks up for disappointment.  Or worse.

The current low-vol environment is not unprecedented.  But today’s combination of low vol and low rates has pushed option prices to the lowest levels in decades.  Consequently, we think a fully invested Don Draper would be well served to buy some protection.  We are.