North Korea has once again chosen to test the resolve of the Trump administration and allies of the United States by launching a missile over Japan. The rocket broke up during its flight, but nevertheless caused the Japanese government to issue an emergency alert to its citizens to seek shelter in the event that debris or potentially a warhead of some kind were attached to the missile. The Pentagon has confirmed the launch, and the Trump administration has vowed, along with Japan, to increase pressure on North Korea.
It seems clear to some that further sanctions are not an option, given the long history of sanctions on North Korea failing to result in the regime backing away from its clear commitment to bolstering its military capabilities. The VXX etf, which tracks the volatility index known as the VIX, is currently up over 6% in overnight trading. We can expect the S&P to open lower as well, given that global equity indexes have traded lower on this news. We shall see what the ultimate response to North Korea will be, so we’ll keep an eye on this situation for further developments. More volatility seems likely as this situation is likely to escalate.
On Wall Street, the phrase “active managers” is used to describe managers that do not passively invest to follow an index, but those who are trying to beat the market on a daily through annual basis. Most of these active managers are running hedge funds.
You may have read over the last few years that many of these hedge funds, even very large and famous funds, have returned money to investors and closed their businesses. Why? Because with the global central planning through various types of QE, hedging is a losing strategy. Additionally, volume and volatility are abysmal as I have written about on numerous occasions. Below is a chart that shows how cumulative alpha has declined with the rise in global QE (which is inverted on the chart).
Citibank’s Matt King agrees, and says active managers should pray for a bear market so that this will end.
The more the markets rally, the more money is crowded into ETFs and other passive index strategies, the more dispersion and volatility are suppressed, the harder it is for active managers to outperform and the greater is the tail risk – even as most asset classes do very well, asset managers get bigger, central banks think they are doing a good job and the world appears to be a safe place.
But groupthink and herding are in themselves dangerous. Stability breeds instability, as Minsky’s financial instability hypothesis famously put it. The harder central banks push, and the more markets rally, the greater the risk of an abrupt correction. The paradox for central banks is that achieving long-lasting stability may require a little bit more instability, a little bit more volatility, in the short run. A tantrum now might well restore balance to markets and help avert a full-blown crisis later.
The paradox for active investors is that such a tantrum or correction will almost certainly be associated with outflows from both ETFs and mutual funds. And yet it is precisely such an environment which active managers need in order to be able to outperform and stop forfeiting money to ETFs. The prolonged bull market which made them so big is also contributing to their undoing; in order to survive, they should be praying for a bear market.
Nowadays, however, it seems like no matter what happens, the global central planners will not allow the markets to go lower.