One of the more fascinating aspects about people and markets is how uncertain we are about what will happen next, yet so cocksure in our explanations of what just occurred. This raises an overlooked question: If it were so simple and predictable — obvious, even — then why didn’t we see it coming in advance and prepare for it?
Today, we shall consider some of the causes of the past week’s market unpleasantness. But before we do, we need to preface our remarks with an admission of error. Our wetware suffers from what psychologists describe as narrative fallacy and hindsight bias. In short, as a species we both like to tell stories — it makes thing more memorable — and we believe we have the ability to foretell the future, a power we clearly don’t possess.
With that as a preface, let’s consider some of the explanations for the sudden market correction:
Inverse and/or Short Volatility: The bet against market volatility suddenly blew up when volatility “unexpectedly” returned. I use quotes here because I find it unfathomable that anyone could believe that we wouldn’t see a return to a more normal trading environment. The Great Recession is receding as a once-in-a-generation event, along with zero interest rates, quantitative easing, fears of a collapse of the European Union and so on. Given how unusually placid 2017 was, this failing is even harder to grasp.
Valuations: The problem with blaming valuations for the correction is that since late 2009, people have been complaining that markets are overvalued. Market participants don’t wake up one day, realize stocks are expensive, then cause a correction. Investors have known this for ages.
Risk Parity: This is an odd thing to blame, as risk-parity funds have held up better than most. Cliff Asness of AQR eloquently takes apart this assertion much better than I can.