Though the root causes vary widely, traditionally “volatility events” have a pattern, occurring roughly every 10 years. Black Friday in 1987, the Asian Financial Crisis that kicked off in late 1997 and the Global Financial Crisis that began in 2008 all impacted the markets and investors in significant ways, but there were certain rules to the chaos that managed to hold true.

“This time it’s different” goes the old cliché, but this time it really is different. For the first time in the 25 years that I have been managing risk, two relationships that were so consistent that they could be considered “elemental facts” of the market no longer hold true and the implication of these un-couplings could have profound impacts on the portfolio construction process.

The first “elemental fact” is that emerging market volatility trades higher than U.S. volatility. Not anymore. For instance, in June, the VIX traded higher than the CBOE Emerging Markets ETF Volatility Index (VXEEM) on ten of the twenty-six trading days.
The second “elemental fact” is that when the VIX spikes this high for this long the root cause could always be found in the credit markets. However, due to government purchases in credit markets, that relationship has evaporated.

In other words, equity markets are hedging for a crash, while credit is implying “nothing to see here.”

A Bull Market In Dysfunction
U.S. equity markets seem more than a bit dysfunctional at the moment. This has been a rally many investors don’t fully believe in, and as a result, they are buying very expensive puts to protect against downside risk, which shows just how much future uncertainty is being priced into that market.

In equities, the lack of clarity around earnings combined with the new normal of “expectation management” on earnings per share beats (meaning it’s easier to beat when expectations are so low) and the residue of the Fed’s intervention in the credit markets continues to make traditional aspects of investment analysis difficult to decipher. Investors must be asking themselves (as much as I am), if the S&P P/E is 8 when the 10-year treasury is at 15%, where should the P/E be with the 10-year near 0?

And don’t ask investors in Europe or Japan if you’re looking for a ray of light. Recent history indicates that zero percent rates have not been positively correlated to returns in either Japanese or EU stock markets.

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