Complacency or Reality?
Sept. 11, 2001 caused an explosion in volatility as investors tried to discern what reality was to look like going forward. Systematic risk completely dwarfed unsystematic risk as investors forgot about individual company fundamentals and focused on world events.
In August 2001, at-the-money 50-day implied volatility (relative option prices) stood around 17% (implying a 17% move up or down in the index). For the next 18 months, implied volatility reached levels as high as 35% and probably averaged 25%. Today they stand again at 17%.
These facts beg the question, is risk in the stock market the same as it was before Sept. 11, 2001? Perhaps it is or perhaps the market is looking in the wrong places.
As I wrote about in my piece, High Volatility, rightly or wrongly, I believe that there is a high correlation between debt and volatility. I am not a buyer of volatility (long options, long gamma) because I am worried about terrorism. I am a buyer of volatility because the government is conducting monetary and fiscal policy at levels that warrant the term "experimental." I am a buyer of volatility because over the last few years this nation has created debt (through excess liquidity) at all levels (public, corporate, and household) at an unprecedented rate (total U.S. debt now stands at 300% of GDP). In buying volatility/gamma I have been targeting companies with very high leverage. This is not a statement of whether these stocks will go up or down in price, just one on how fast and how far they will go.
Most market participants have been persuaded that debt should not be an impediment to consumption nor does it present unmanageable risk. I do believe that debt is at levels where it is acting like an anchor: no matter how high the water rises (liquidity), the anchor won't let the ship sail. So reading between the lines I am bearish, but I learned a long time ago not to make my major bet on market direction. I am making my major bet that implied volatilities are too low, that stocks will move more (and that there is more risk) than the options are charging us for.
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