VolatilityandtheUnknownTreyTaylorJune2,2017

If you put off everything

till youre sure of it, youll
get nothing done
 Taylor 2

Itisnotpossiblenorsensibletoformpredictionsintothefuture.However,intimeswhen
currentconditionspresentdubiousforecasts,itisimperativetokeepinmindourperspective.As
MarkTwainpensinTheGildedAge:ATaleofToDay,Historyneverrepeatsitself,butthe
Kaleidoscopiccombinationsofthepicturedpresentoftenseemtobeconstructedoutofthe
brokenfragmentsofantiquelegends.WhileTulipmaniaorBlackMondaywillnotidentically
reoccur,wecanusesucheventstolearnfromthepastandevaluateproperriskreturnprinciples
todevelopourguidetocurrentmarketconditions.Althoughthefutureisalwaysunknownand
unforeseeable,ifweincorporatehistoricalexperienceswithforwardlookingexpectationswe
mayanalyzesuchscenarios.
Between1950and1960,economistsusedadaptiveexpectationstheorywhichformulated
businessandconsumerexpectationsbasedonpastexperiencesandsuggestedchangewilloccur
slowly.However,sincepeopleholdmoreinformationthanjustpastdata,adaptiveexpectations
theorywasrelativelymisleading.Inresponsetosuchoutlook,JohnMuthestablishedan
alternative,rationalexpectationstheory,whichforecastsexpectationsusingallavailable
information.Inretrospect,anyexpectationcanbeputinoneoftwobuckets;whatwas
predictableandwhatwasunpredictableevenlookingback.Anticipatedeventssuchasthe
Dot.comBubbleor2008FinancialCrisis,whileunforeseeneventsincludeBlackMondayorthe
FlashCrash.However,wemustalsoconsiderthethirdtypeofoccurrence.AsDonaldRumsfeld
exSecretaryofDefensefamouslysaid,thereareknownknowns;therearethingsweknowwe
know.Wealsoknowthereareknownunknowns;weknowtherearesomethingswedonot
know.However,therearealsounknownunknownstheoneswedon'tknowwedon'tknow.
Andifonelooksthroughoutthehistoryofourcountryandotherfreecountries,itisthelatter
categorythattendtobethedifficultones.WhileRumsfeldmightsoundlikeahyperbolizing
politician,theseeventsarerelevanttorisk.Thereknownriskswhichwecanandcannotquantify,
andtherearealsorisksareunknownthatwecanbeabletoquantifyandbutalsocannotquantify.
Afterthe2008FinancialCrisis,anewparadigmforpricingriskhasdeveloped,andthenext
unknownunknownisfurthereminent.Whileadaptiveexpectationshaveallowedforvariable
changeandshiftingexpectations,predictionsmayalsoartificiallycreateoptimalestimatesusing
goalseekingpredictionmodelsbasedonfaultyconclusions.Infact,theriseofbigdataleading
totheuseofalgorithmsandfintechinstrumentshaveextendedrationalexpectationtheory.Such
modelshavechangedourperceptionofriskbyhidingstructuralproblemswithimperfectmodels
thatremainuntestedduringrecentrecessions.Attemptingtounderstandrecessionprobabilityis
nearlyimpossibleasevidencedbyGraph2thateventheDallasFedcannotproperlymodel
recessionsprobability.
ArecentarticlebyinvestmentmanagementfirmPIMCO,PivotPointsputforththeir
probabilitymodeltoevaluatesuchfuturemarketconditions.Thearticleannounces,ifhistoryis
anyguide,webelievetheprobabilityofarecessionsometimeinthenextfiveyearsisaround
70%.Ifthisisthecase,wemustconsidersuchscenario.Ianalyzedthreefiveyeartimeframes
ofgrowth,followedbytwoyeardownturns.AsdepictedinTable2,theyears1995through
2000,2002through2007,andpost2009S&P500showsperiodsofboom.Conversely,during
theDot.comCrashof2001and2008FinancialCrisisbroughtyearsofdecline.Thefiveyear
growthduringbulltermsaveraged192%,whilebullperiodssawanegative51%decline.From
thisboombustmodelalongwiththenumberspresentedbyPIMCO,Iprojectameanexpected
returnofnegative23%withinthenextfiveyears.Whilethisexerciseusesimperfectpast
 Taylor 3

historicaldata,theresultsshowifthesemodernscenariosduplicatepastpriceactionthenthis
deservesourattention.Evaluatingcurrentexpectations,wecantheorizeonmiscellaneous
macroeconomicshiftersaswell.Inthenextfiveyears,UnitedStatesfiscalpolicyshouldinclude
taxcutsaswellasincreasedspending.WecanassumethattheFEDwillbegintonormalize
balancesheetandincreaseinterestrates.InternationalconcernsincludeItalianBanks,Greek
debt,andcontinuedBrexitfalloutuncertainty.ConcernsofChinseeconomiccollapsebuoyin
thehorizonbutXiJinpingsdefectNewSilkRoadposesuncertaintimehorizons.Bilateraltrade
dealswithChina,Russia,andothernationsprojecttowidentradepolicyasPresidentTrump
seekstoreducethedeficit.Again,theriseofthequantshasalsoheldanundeniableeffecton
markets.Thesemodelspredictallknownvariablesbridgingthepast,present,andfuture
estimatesandcontinuebecomingmoreefficient.Skepticsarguethatevidenceusinghistorical
backtestingwillprovetobeineffectiveinthelongrundespiteshortrunprofitdueto
underpinnedstructuralrisks.Indeed,theseassumptionsarenotfact,butwecanusesuch
assumptionsasmacroeconomicexpectations.Indeed,sometrancheswillfallflat,yetasset
allocationcontainstheadvantageofshieldingriskfromoverweightmarketconditionsand
identifyingmarketsthatwilloutperform.Recentlowvolatilityfiguresmayprovideablueprint
movingforward.
TheVolatilityIndexevaluatesthisdifferentialbetweentheperceptionoftheworldandas
itexists.AsevidencedinGraph1,Volatilitysitsatitslowestpointinyearsanddubiously
mirrors2007.Whetherthisrepresentsaneerielullornot,whatiscertainistheunknownmarket
expectationshavepeaked.Unusuallylowvolatilityhaspavedthewayforquestionsabout
unknownandunquantifiableevents.Whatisunforeseenisrealgrowingthreatstooureconomy
goneunpricedwithinthemarket.Theriskrewardparadoxiscriticalwhenunderstandingthat
riskcompensationforwithrewardonetoone.Greaterriskshouldseehigherexpectedreturns.
However,thismuchhasfailedtocometrueincurrentmarkets.Whileaprojectionofarecession
basedonsuchproblemsisnearlyimpossibleandtiming,themarketisanearfataltask.
However,tacticalassetallocationcantakeadvantageofcurrentconditions,goodorbad.The
roleofsuchstrategyisnottopredictthefuturebuttoidentifymispricedrisk.
Toevaluateunknownconditions,wemustprepareforunknownunquantifiablerisks
whenevaluatingwhatwecanforecast.Whilechartingunknownterritory,theinfluenceof
adaptiveversusrationalexpectations,understandinghistoricalmodelswithinpresentday,and
understandvolatilityasametricareimportantconsiderations.Overpricedassetsusuallycontain
marketidentifiedriskandthusshouldincludesuchcompensation.Asfurtherevidencedinthe
volatilityindexandexplainedthescenarioanalysis,unknownanduncalculatablesystematicrisk
arenotbeingrewarded.Eminentgeopolitical,economic,andunknownrisksarepeakingwhile
theVolatilityIndexisflat.Risingconcernsarounddebtandcreditdefaultarerealdriversof
uncertainty.Thus,mispricedmarketsareevident.ToreiterateMarkTwain'sthoughts,history
doesnotrepeatitself,butitsuredoesrhyme.Althoughthenextfiveyearswillcontainan
inevitablemarketshift,allocationandmodelsshouldreflectpragmaticexpectations.Uncertainty
aboutthefuturewillremain,buttheansweriswhereriskfullyreciprocatesreturn.
 Taylor 4

Graph1

Table1

ScenarioAnylasisonModernBubblesintheS&P500

Time Start End Return Event Er Prob Mean Er VAR SQ Dev Mean VAR
1995-2000 450 1500 233.33% Bull Market 1.92 5% 0.10 0.33 0.11 0.01
2000-2002 1500 808 -46.13% Steady Growth 0.19 15% 0.03 0.26 0.07 0.01
2002-2007 808 1525 88.74% Recession -0.51 70% -0.36 -0.12 0.02 0.01
2007-2009 1525 681 -55.34% -0.23 VAR 0.03
2009-2017 681 2415 254.63% Outlook STD 0.16
2017-?Bear 2415 1190 -50.74% Current 9.50% 2415
Bull Market 9.60% 2646.84
Steady Growth 450 2415 18.99% Steady Growth 2.85% 2483.83
Bull Market 192.23% Recession -35.52% 1557.26
Recession -50.74% Projection -23.07% 1857.93

Graph2
 Taylor 5

Works Cited
Cole, Chris. "BULL MARKET IN FEAR." (n.d.): n. pag. 23 Oct. 2012. Web.
"Federal Reserve Economic Data | FRED | St. Louis Fed." FRED. Federal Reserve Bank of St. Louis,
n.d. Web. 30 May 2017.
"The Gilded Age." Google Books. N.p., n.d. Web. 02 June 2017.
Graham, David A. "Rumsfeld's Knowns and Unknowns: The Intellectual History of a Quip." The
Atlantic. Atlantic Media Company, 27 Mar. 2014. Web. 02 June 2017.
Richard Clarida, Andrew Balls, Daniel J. Ivascyn. "Pivot Points." Pacific Investment Management
Company LLC. N.p., n.d. Web. 02 June 2017.