Note: The following article is an excerpt from the First Quarter 2011 Letter to Investors from Artemis Capital Management LLC published on March 30, 2011. PDF Download
The financial markets have endured a flock of geopolitical "black swans" including the devastating earthquake and nuclear crisis in Japan, widespread revolution and violence in the Middle East and North Africa, and escalation of the European sovereign debt crisis. Incredibly domestic markets shrugged aside fear from each transformational event as stocks registered their best first quarter in over a decade led by a recovery in corporate earnings and job growth. The absence of sustained price volatility despite several global shock events is interpreted as a bullish omen by many investors. In regard to geopolitical risk it feels like volatility should be perched above 30%, but surprisingly, after increasing in mid-March, the VIX index registered its second largest drop in history (and the third longest) falling -40.86% over seven days and ending the month below historic averages.
The passive mood of spot volatility is masking a dramatic revolution in the structure and behavior of the volatility curve that has wide-ranging ramifications for anyone who trades variance or uses portfolio insurance. The timing of recent volatility distortions has coincided with the implementation of the Federal Reserve's second quantitative easing program and is likely an unintended consequence of loose monetary policy.
In an increasingly volatile world many investors are talking about how to protect their portfolios against the black swan event. What may be more relevant is to explore the psychology of a market that fears the black swan but refuses to acknowledge its presence upon arrival. In behavioral psychology this is called a "normalcy bias" and the concept provides a framework to understand the current volatility market.
Normalcy Bias and Crisis: A quirk of the human condition is for the mind to desire normalcy so intensely as to consciously or subconsciously disregard knowledge that is disruptive to a pre-conditioned reality. This phenomenon is an important part of crisis management and market psychology. The consequence of a normalcy bias is that warning signs of a potential crisis go unnoticed or are interpreted optimistically. When a crisis occurs people are so overwhelmed by events inconsistent with a desired reality they lose their ability to make decisions. Researchers believe when the mind encounters an entirely new experience or event it attempts to match that reality to relevant experiences from the past. If there are no matching experiences the mind enters into a kind of feedback loop resulting in passivity. This lack of action as a response to risk is called negative panic1 and it culminates in a dangerous inability to act assertively in crisis. In essence, the psyche struggles to come to terms with what is really happening. Paralysis follows.
On November 18, 1987 a fire broke out during morning rush hour in the crowded King's Cross Underground station in London. The Underground staff was unprepared for the disaster and failed to initiate an appropriate emergency response. As the fire spread ferociously the trains kept arriving at the station dropping unwitting passengers into the thick of the disaster. Incredibly many commuters simply carried on with their daily routines despite the presence of thick black smoke coming from the station. In some cases commuters boarded escalators that carried them directly into the fire. One irritated woman even asked a manager if her morning train was canceled apparently unaware that people were dying just below her. In total 31 people perished in the accident, many of them from passivity.
On March 27, 1977 644 people lost their lives in one of the worst disasters in aviation history when a KLM plane collided with a Pan Am aircraft on a runway in the Canary Islands. Based on interviews with some of the 64 survivors, the passengers aboard the Pan Am craft had enough time to evacuate but many remained paralyzed in their seats even as flames were observable in the cabin. Many would have survived if they had just evacuated.
Negative Panic = Negative Volatility: In financial markets normalcy bias provides a psychosomatic explanation as to why lower than appropriate volatility can be sustained for long periods of time despite increasing signs of systemic risk. This phenomenon was observable in 2007 as volatility remained at extremely low levels even after problems in the subprime housing market began to take root. The volatility of asset prices is widely considered a metric of fear and panic in financial markets, therefore the lack of sustained volatility following a market shock event could be viewed as a form of negative panic. If we accept that investors may subject to a consensus normalcy bias then it is logical to accept that negative volatility can also exist as a quantifiable response to exogenous shock events. Admittedly this may sound odd since volatility, by mathematical definition, can never be negative, so the term refers more to a cancellation of short-term volatility risk premium that should otherwise exist. The theory of negative volatility is a temporary state of low volatility caused by the market's failure to acknowledge the enduring risks of a black swan event. The concept may go a long way toward explaining why high geopolitical risk can co-exist with extremely low volatility in the current market. The physical passivity of a person who psychologically denies risk is analogous to a kind of low volatility. The paradox of the new volatility regime, similar to the concept of negative panic, is that it personifies two dimensions of fear that exist concurrently at the same time. One dimension is passivity and the second dimension is great peril. The theory of negative volatility bridges the psychological disconnect between these two vastly different worlds of risk. For example, the optimism of an economic recovery is reflected in lower spot volatility but exists simultaneously with a steep volatility curve that warns of great systemic risk. Volatility is now a market of risk duality. This is a negative volatility regime.