"Just who believes in the "consensus view" that "all is for the best in this best of all possible financial worlds"?

Historically low equity volatility, historically low credit spreads. So the markets, in a collective sense, are believing that there's not going to be much turmoil.

That hits the nail on the head, Andrew. A -lot- of smart people see bears in the woods, but financial assets are priced as if we have climbed atop a permanently high plateau.

I like to think of the market as a mind, with asset pricing analogous to consciousness--some continuum of elastic to synthetic collisions of perceptions, conceptions, memories, etc., collapsing at every moment into a bounded output.

If so, what/who in the real world corresponds to the overriding complacency of the market's mind at present? I have a sneaking suspicion that it is "mustmoney"--mutual funds + institutions that must keep investing, together with all the dollar-cost averaging in the world. But I am far from satisfied with that as an explanation.

Those seeing bears lurking within the forest of U.S. financial markets include:

some (maybe many--I don't know) economists in the academy

some Wall Street economists

a lot of hedge fund managers

value investors (Grantham, Buffett)

foreign investors (much more pessimistic on bonds than stocks)

CEOs--insider sentiment as measured by stock purchases has been low for some time.

I -really- don't understand why option protection from stock market losses (cf the VIX) is so cheap right now. Are we still in a bubble?

If you think vol is mispriced (i.e., the markets are mispricing the risk of a market collapse or rally) you can trade CBOE variance futures which pay off according to *realized* SP500 volatility.

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Comments on volatility

The comments below are from a practitioner in quant finance. I find his explanation of why implied vol is so low to be persuasive. The "technical" cause he mentions (people writing a lot of covered calls) leads to skew - asymmetry of the implied prob. dist., with upward moves of the spot less probable than downward. I'm a bit confused about whether this affects the relation between implied and realized vol - it depends on why the calls are being sold. BTW, I also recently learned that one can directly trade realized vol through CBOE variance futures.

http://infoproc.blogspot.com/2004/12/comments-on-volatility.html

Well, one component of that consensus would seem to be the economics team at Morgan Stanley. At least that is the impression I took away from Stephen Roach's last memo (22 Feb, I think), in which he tries to imply that he thinks his team is completely wrong, without actually saying so in so many words.

my view is that the market is priced by a lot of people who believe there is a consensus that this is the best of all possible worlds, whether they the price-setters believe it or not.

i suspect we have a lot of people afraid to leave the party too early, even though there are clear indications that the party will end badly, and so are behaving as if there are no such indications after all.

steve-

That is a super link--about four things in there that were totally new to me. Thanks much.

How far out do those variance futures go? My gut tells me that financial Armageddon derivatives would be more likely to be underpriced the longer their horizon.

Steve Hsu's interesting comment and post may imply that volatility down in a covered call frame can be more than expected. Volatility up has obviously been muted, and we are in an international bull market that began in October 2002. Then, the absence of volatility should not be taken as an affirmation of a continuing bull market.

Sean-

I do sometimes wonder whether Roach and Morgan's U.S. economics team sit together at lunch. It's probably a good thing that Andy Xie is in Hong Kong, too....

Steve: "The "technical" cause he mentions (people writing a lot of covered calls) leads to skew - asymmetry of the implied prob. dist., with upward moves of the spot less probable than downward."

There are a lot of reasons/explanations given for skew - one being people like to write covered calls - but it's not the only one. Here are just a few more:
(1) Investment banks have stress-test limits, and almost invariably, with equal losses allowed, the downward scenario uses a greater movement than the upward scenario. That is, based on historical analysis, people believe that a large downward movement is more probable than a large upward one. This makes volatility on downward strikes more valuable than volatility on upward ones.
(2) It takes time for people to adjust between relative and absolute movements on stocks. Suppose that people think that a movement of 1 on a stock worth 50 is a lot. When it goes up to 100, they still think it's worth a lot, even though in percentage terms it's half as much. It takes time for people to adjust, and so volatility on stocks at higher prices is lower than volatility on stocks at lower prices.
(3) The model of the firm, which says the stock price is actually an option on the value of the company.

Anyway there has always been skew, whether vol levels are high or low. Vols are low, not because of skew, but because you can't make money at this level buying vol, because the markets just aren't moving. Professionals would love to buy vol at this level; it's good deal. The only thing that's stopping them is that it's too painful, in terms of p&l. They have to lose money now, in order (presumably) make money later.

Now this could be the classic chicken-and-egg problem. It could be that some outside participants (like hedge funds) are selling vol Nick Leeson-style to investment banks, whose delta hedge are causing stocks to move less and less. Or it could be, that credit spreads are down, thereby causing selling of stock vol, rather than vice versa. It's really hard to say. Basically the only way out may be a shock to the system, like an earthquake (which did Leeson in) or a financial crisis of some sort (dollar crisis?).

Andrew: very nice comments. I wish I had had access to your post when I was puzzling through this stuff on my blog last December!

I thought that before the 1987 crash there was much less skew in the implied vol? I have a graph that shows this somewhere on my blog.

Nicholas: I forgot how far out they go - only a year? You can follow the link from my post to the CBOE page that describes the variance futures.

When on February 24, we are offered an assessment of how the world stands based on what prices did as of February 23, we really ought to stop reading, right there. One thing everybody who has been around financial markets any time at all understands is that, when somebody who has not yet retired in spectacular wealth "explains it all for you" they are bluffing. "The reason for this week's wobble" is no more evident to the "Economist" writer than to my Aunt Tilley.

Interest rates are still low at the long end. Major US stock indices lost far more ground in January than so far in February. So far this week, the S&P is off less than 1%, far too small a move to need any sort of explanation. The dollar is within the same range against the euro and yen that it has traded since November. Any argument that recent changes in financial market prices reveal thinking by the "market" (that's "people" to those of us who try not to write silly things about markets) is hooey. The author seems to know this (…-"albeit just a little"-…), but feels compelled to make financial market prices part of the story, anyway.

Steve Hsu is right about fairly low volatility in 1987 up to October. Remember though, the S&P index gained almost 45% from January to August. The market retreated moderately till October and then there were the huge losses of Friday and Monday. Then there was volatility till December, when the market quieted at the October low and began steady gains.

KHarris notes low long term interest rates and that is possibly most indicative of this market. The guess is interest rates will be the best indicators from here.

kharris-

"Any argument that recent changes in financial market prices reveal thinking by the "market" (that's "people" to those of us who try not to write silly things about markets) is hooey."

I would agree that recent changes in financial market prices do not reveal thinking by the "market"--through a glass darkly at best, particularly when refiltered by lazy Reuters staffers.

And yet. Start with Ben Graham's "Mr. Market." A very useful metaphor. What do markets do? Process information to reach a conclusion. Isn't that what minds do? If a market is a million minds trying to solve the same problem (how to price all the assets in the world) at the same time, just how does that take place? Buy/sell. 1/0. Neuron on/Neuron off (brain's network is much richer in connections, though). Compare Marvin Minsky's neuroscientific speculations in -The Society of Mind-. Why does the market seem to be able to outthink individual minds most of the time? Is it dumb or smart, and if it is dumb, why is it smarter than we are? If it is smart, is it mindful?--probably not, but it is mindlike.

Some metaphors become words--and why is that?

"I thought that before the 1987 crash there was much less skew in the implied vol?"

Before my days, I'm afraid...

But yes I think you're right - in 1987 the last crash, 1929, was a distant memory and considered a one-off, so there was little to no skew.

Andrew: I knew I had seen a plot of the vol smile pre- and post-1987, but it was in Derman's autobiography "My life as a Quant," which I reviewed on my blog. Sorry I didn't really post the graph...

"One tantalizing fact I learned from the book is that prior to the 1987 crash there was no vol smile in SP options. This strongly suggests to me that the smile is at least partially caused by crash-averse portfolio managers buying puts as insurance and selling calls to defray the cost of that insurance (or simply to enhance profits). Puts would then be overbought while calls are oversold."

http://infoproc.blogspot.com/2004/12/life-as-quant.html

So the markets, in a collective sense, are believing

There is a Hayekian argument about this, which I really do now think I am going to have a to write a monograph on or something in order to kill this one dead.

Markets don't believe, collectives don't believe, and "Mr Market" is a really bad and misleading metaphor. Markets organise tacit information. That is, they *organise* information, not process it, and they deal in *tacit* information, not propositional information. The concept of a catallaxy is of a social organisation which brings together production and consumption so as to optimise the process. It it a modern vulgarisation of the catallaxy to think of it as a computer.

To put it more dramatically, think about it in the context of the socialist calculation debate. The *wrong* way to think about this debate is to have an image in your mind of "Mr Market" as a sort of distributed planner, taking in the inputs, forming a plan and matching them up to the outputs. That's actually a much less radical reinvention of the concept of a market than the one which Hayek and von Mises had in mind. They were radical methodological subjectivists, and it's not at all sure that they would regard the question of whether market prices processed information about the world as a meaningful one.

Prices are epiphenomena. The record of historical prices (and thus its descriptive statistics like historical vol) is simply a record of what transactions were carried out in the capital market. The prices quoted in the market for option premium (implied vol) is simply the price at which a market maker is prepared to sell or buy insurance.

In other words, a price of insurance does not map one to one on a set of beliefs about the future direction of the market; it's simply an atomic action taken in the catallaxy of purchases and sales of insurance.

What is an investor to learn from this post and interesting discussion? Is the low volatility deceptive or dangerous? Why? Is the implication that downside risk is actually increasing? What is the implication? Please give me more of sense of what I may learn from this discussion.

Steve, Anne, K Harris, Andrew, DD?

Nicholas,

Even useful metaphors distort. We ought always to remember that metaphors are metaphors. The metaphor in which markets "think" for instance, anthropomorphizes a process which, as you note, ends up reflecting the thinking of lots of people. Markets reflect a very special process which aggregates the results of many people's thoughts – not even their thoughts, but the results of their thoughts, in terms of buying or selling financial assets. That process is not thinking. Markets do not "outthink" individual minds – they simply attach prices to assets. Those prices often provide more accurate insights than individuals can regarding uncertain events, but that does not equate to thinking.

The reason I am prickly about the assertion that markets think is that it is such a degraded notion. The metaphor has become a cliché for every weak-ass financial reporter, every analyst who hasn't thought through what he or she means thoroughly enough to go beyond clichés in conveying their views. "What the markets are telling me is…" – just awful. In the present case, having the writer include the notion of markets "thinking" along with a bunch of other half-baked stuff just makes me see red.

As I prepare to post this, I see that dsquared got here first. But what the heck, it's written…

Lise,

There may be a good bit to learn in the technical sense from the discussion of implied volatility. Otherwise, I vote that what we have learned (again) is that the "Economist" isn't good for much other than drawing our attention to international stories not covered in major US press outlets.

The apparent stability in the value of the dollar and low interest rrates in the U.S. mask a very dangerous dynamic. Up to this point, OPEC, Europe, the central Asian banks and the United States have all benefited from a situtation where the U.S. imports goods and exports dollars. The level of the trade deficit is unsustainable, but every player has a stake in maintianing the status quo. This is extremely dangerous because it makes gradual adjustments impossible. This is a global game of chicken, and at some point one player won't want to be caught holding dollars that are highly overvalued. The correction will be very quick and very harsh.

By all measures, dot com stocks were ridiculously over valued. But every player in the market had a stake in maintaing the illusion that the economic rules had changed. On April 21, 2000 the stock market lost $2.1 trillion with the collapse of the dot com stocks that were a relatively insignificant part of the economy. The dollar collapse will be much greater.

Thomas Friedman recent op ed pice about the dollar has been heralded by some concerned about the unrealistic value of the dollar. But by beginning with a discussion of Belgian chocolates he vastly understates the consequences of America's twin deficits.

KHarris and Steve Hsu

Thank you. Wading through all of the technical analysis is important, but I too needed to know if I had missed the current importance of the issue. I gather the current importance of lack of volatility is only that it tells us of the considerable amount of hedging going on which appears to be limiting sharp up movements of the market. Hedge fund assets alone run over a trillion dollars now. This is indeed a curious market in technical terms.

Think of it as an insurance market. When reinsurance rates fall, does this mean that the reinsurance companies of the world have become more optimistic about the weather? Nine times out of ten, the answer is no; it means that the reinsurance industry is overcapitalised and returns have fallen, so they are looking to make it up with volume. The market for "implied volatility" is similar (I have long been a lobbyist for getting rid of the term "implied volatility" and using the much more neutral term "option premium").

dsquared-

"Markets organise tacit information. That is, they *organise* information, not process it, and they deal in *tacit* information, not propositional information. The concept of a catallaxy is of a social organisation which brings together production and consumption so as to optimise the process. It it a modern vulgarisation of the catallaxy to think of it as a computer."

OK--here is some AI/neuroscientific stuff--two geniuses thinking about robots in the 60s:

In particular, Minsky and Papert found that no single algorithm or method was adequate for solving even the simplest-seeming problems like assembling towers of blocks.

In trying to make that robot see, we found that no single method ever worked well by itself. For example, the robot could rarely discern an object's shape by using vision alone; it also had to exploit other types of knowledge about which kinds of objects were likely to be seen. This experience impressed on us the idea that only a society of different types of processes could possibly suffice.

Ultimately, these kinds of experiences led Minsky and Papert to become powerful advocates of the view that intelligence was not the product of any simple recipe or algorithm for thinking, but rather resulted from the combined activity of great societies of more specialized cognitive processes. However, there were few ideas at the time for how to understand and build systems that engaged in thousands of heterogeneous cognitive computations. The conventional view within AI for how problem-solving systems should be built could well be summarized by this statement by Allen Newell from 1962:

The problem solver should be a single personality, wandering over a goal net much as an explorer wanders over the countryside, having a single context and taking it with him wherever he goes.

But in Minsky and Papert's experience, this 'explorer' was being overwhelmed by the sheer magnitude of tasks and subtasks encountered in ordinary commonsense activities such as seeing, grasping, or talking. The emergence of this unanticipated procedural complexity demanded a theory for how such systems could be built.

Which leads to the theory:

The mind is a community of 'agents.' Each has limited powers and can communicate only with certain others. The powers of mind emerge from their interactions for none of the Agents, by itself, has significant intelligence. Everyone knows what it feels like to be engaged in a conversation with oneself. In this book, we will develop the idea that these discussions really happen, and that the participants really 'exist.' In our picture of the mind we will imagine many 'sub-persons', or 'internal agents', interacting with one another. Solving the simplest problem, seeing a picture, or remembering the experience of seeing it might involve a dozen or more, perhaps very many more, of these agents playing different roles. Some of them bear useful knowledge, some of them bear strategies for dealing with other agents, some of them carry warnings or encouragements about how the work of others is proceeding. And some of them are concerned with discipline, prohibiting or 'censoring' others from thinking forbidden thoughts.

http://web.media.mit.edu/~push/ExaminingSOM.html

I suggest that Minsky's theory of intelligence is analogous to your catallaxy organizing tacit information.

Wikipedia tells me that Hayek is one of the sources of the "connectionist" theory of neural networks.

Oops, I did actually post the data. It is here:
http://infoproc.blogspot.com/2004/12/historical-volatility-smile.html#comments

Regarding the general meaning of all this:

Realized (actual) volatility in the markets *has* been low recently. Very hard to explain why, but hedging may have something to do with it. Also, the cost of vol/options/portfolio insurance ("implied vol") is historically very low right now. These two observations are not unrelated, but causality is difficult to determine :-)

I think what Andrew Boucher said above captures it well (my comments in [ ..brackets.. ]):

"Now this could be the classic chicken-and-egg problem. It could be that some outside participants (like hedge funds) are selling vol Nick Leeson-style to investment banks, whose delta hedge are causing stocks to move less and less. [Someone is selling vol too cheaply - you should buy vol!] Or it could be, that credit spreads are down, thereby causing selling of stock vol, rather than vice versa. [Vol is cheap because company balance sheets are very positive, with lots of cash on hand - prob. of a crash is small] It's really hard to say. Basically the only way out may be a shock to the system, like an earthquake (which did Leeson in) or a financial crisis of some sort (dollar crisis?)."

Practical note: if you want to be long stocks, you can construct a synthetic portfolio right now with call options that will give you all the upside of the SP500, but very little downside risk. If you think there is a reasonable chance of a crash in the next year or two, this might be a good trade.

Excellent. Thank you all, for the explanations.

George Bush is a moron. We can recognize that without needing to claim that every single thing in the American economy is an accident waiting to happen.

Vix is trading at 11.5%, marginally above realized vol in equities. Realized vol has fallen in line with balance sheet deleveraging during the past two years. During the mid-1990s, realized equity vol traded in a range of 5 to 10% for extended periods, long before the bubble took hold. In fact, to the extent that bubbles reduce the ERP and discount factor while encouraging corporate leverage, they should result in higher -- not lower -- equity price volatility. Logically and empirically, there is no link between low VIX and an equity bubble. Nor is there an equity bubble. Equities are cheap to bonds. As for bonds themselves, folks seem to think the problem is one of scarcity. I guess we will find that funny in a few months, but I don't really claim to know.