For some time now, we have hardly been alone in showing charts of the extreme valuations extant in markets. Central Bank-driven lows in the complex of so-called ‘riskless’ interest rates have unleashed an interlocking series of mutually reinforcing feedbacks (or, rather, vicious circles) which have led to the forced acceptance of unconscionable levels of risk. Stock valuations are high and recent returns have outrun those delivered by bonds and commodities to a degree without precedent, except in the heady whirl of the (first) Tech Bubble, back at the turn of the millennium. Bond durations are extreme, coupons exiguous, and yields in some cases still negative—not much room in your pension fund for any adverse change in circumstances on that account, is there, Grandma? Credit spreads on the more déclassé of securities, whether junk or emerging, have collapsed, covenants have once again been eroded, and even one of the principal perpetrators of the late catastrophe—the CDO—has secured an early release from the slammer, along with his junior accomplice, the CLO. All of this has allowed multiples and valuations to build up alarmingly in the buy-out and buy-in business where the average EV/EBITDA ratio of 13.2x in the US is now tying with 2014 for the all-time top spot of cash-soaked exuberance. And then there is volatility. Just a few weeks ago, we saw the VIX dip briefly below 10% for the first time in its 27-year history (a sample stretching to over three decades if we further estimate the measure from its narrower but more venerable VXO stablemate).
Finding ways to be short of the measure—and by extension, of many more implicit forms of gamma— had accordingly turned into the classic game of ‘picking up pennies in front of a steamroller’. When it suddenly exploded this week, the VIX jumped straight to the 99th percentile of that same distribution, touching 50 intraday—a number only exceeded around the Lehman bankruptcy and during the epochal Crash of ’87. That was enough to trigger all manner of hedging flows, portfolio rebalancings, black box stop-losses, and marginrelated selling as the stock market hit an air-pocket and surrendered half the gains made in the past six, extraordinary months of relentless ascent, amid some very Hooverian platitudes from those in power to the effect that ‘the fundamental business of the country is on a sound and prosperous basis.’ The markets having since struggled to regain even the most edgy of equilibria, the question is whether this was a salutary ‘remember, thou art mortal’ alarum or the first crack in the towering dam of investor insouciance, erected over this past decade of determined, politically-inspired risk suppression. Each successive failure to sustain a rally from here can only give growing support to the second, darker interpretation. In markets such as this, what does not go up, must instead come down.