Normal valuations are more required than calm

After enduring something of a sudden trauma last week, many market participants now wish for a rapid return to calm.

That’s understandable, but it may not be in their longer-term interest to simply revert to the highly unusual market conditions that prevailed before. Instead, they should hope for a new, less abnormal market paradigm with respect to asset-price volatility, correlations and certain asset class valuations, together with less extreme investor-base conditioning.

During the recent bout of intense market turmoil, the VIX measure of volatility surged from less than 14 at the end of January to more than 37 just five days later. Major stock indexes corrected by 10 per cent in a few days, after more than 400 days when the S&P 500 had not experienced a cumulative 5 per cent drop from its most high. And while a daily move of 100 points in the Dow Jones Industrial Average had become unusual, 1,000-point intraday journeys suddenly were common.

Adding to investors’ disquiet was a concurrent decline in the price for fixed-income exposure, which dented the risk-mitigation effectiveness of well-diversified portfolios. And this all occurred in the context of technical-driven market moves that contrasted with the generally improving economic and corporate fundamentals.

The impact of the recent bout of market volatility also highlighted the fragility of certain investment approaches and products. The sudden price collapse of very popular short-volatility strategies was accompanied by the demise of a handful of related products and some asset-class contagion. Then, retail investor outflows from stocks and other risk assets spiked.

It should come as no surprise that many investors yearn for a return to the comforting calm of 2017 and January of this year. Yet when judged against history, those circumstances were even more unusual and peculiar.

Stock prices were essentially going only one way until the end of January; the Dow recorded more than 70 records in 2017 alone. Virtually all asset classes were increasing in price, regardless of historical correlations. Volatility was almost non-existent, with the VIX registering six of its seven all-time lows last year. Meanwhile, both product providers and users capitalised on the intense romance with exchange-traded funds. In so doing, some ventured into more exotic areas where, importantly, the implicit/explicit promise of the product – that of instantaneous liquidity at reasonable bid-offer spreads – would be hard to fulfil if these segments reverted to their usual structural condition of more patchy liquidity.

All of this was underpinned by excessive investor confidence in the ability of “non-commercial” market participants, central banks or liability-driven corporate investors, to continuously and always repress volatility. With that came conditioning to buy the dip at ever-higher prices, regardless of the cause of the price pullback. Consequently, dips became less frequent, smaller in magnitude and shorter in duration – all of which reinforced the abnormal price and market conditions.

Investors should hope for a transition to a new and orderly market paradigm that could include five immediately observable aspects:

1. Volatility trading at higher levels than in 2017, and in a relatively rangebound fashion (mostly 15 to 20 for the VIX, which is currently trading at 25).

2. The yield on the 10-year government bonds trading mostly in a 2.7 percent to 3.1 percent range for now (it is currently 2.8 percent).

Investors should hope for a new, less abnormal market paradigm with respect to asset-price volatility

3. The yield differential between 10-year US and German government bonds trading mostly in a 195 to 225 basis points range (currently 210 basis points).

4. The correlation between risk assets and risk-free assets regaining their historical (negative) relationship.

5. Currency markets taking on more of the role of two-way shock absorbers.

Behind the scenes, market participants would gain greater respect – and better pricing – for liquidity and volatility, which would also bring discipline to an excessive market phenomenon of over-promising liquidity in inherently less liquid asset classes.

These conditions may not be as rewarding as those that existed before the February turmoil. But they would underpin a healthier market in the long term, especially if fundamentals continue to improve and eventually provide solid valuations.

Mohamed El Erian is the chief economic adviser at Allianz