Flying Too Close to the Sun

Many have heard the ancient Greek myth of Icarus, the boy who was granted the gift of flight by his father who crafted wings out of wax and feathers in order for the duo to escape the labyrinth to which they were confined. Icarus’s father had only one warning for his son and that was to not fly too close to the sun and to follow in his father’s flight path. Tragically, Icarus did not follow his wise father’s advice and flew so close to the sun that his wings melted, prompting him to fall into the sea and ultimately drown. People often quote this tale as an example of the foolishness of youth, while others look at it as a lesson in hubris. For investors, it is a cautionary allegory about taking too much risk and naïvely believing that the system, and the feedback loops within it, will continue to work exactly as anticipated. In this long form piece published by Newfound Research, Corey Hoffstein introduces us to what he calls the Market Incentive Loop. This loop, which is caused by modern market phenomena, introduces increasing levels of fragility to the system by way of divergent trades and a mismatch in liquidity needs and liquidity availability. The loop is then closed through central bank intervention and allowed to continue, arguably with more fragility.

It started with the experimental monetary policy that the Federal Reserve embarked on in 2008, which has culminated in extremely low interest rates. The Fed’s interventionist policy has resulted in providing investors with incentive to bear more risk in search of yield and, through market stabilization programs (i.e., emergency liquidity injections), investors have been given the confidence to do so. When markets inevitably fall, over-levered investors, or simply those who have taken more risk than they can tolerate, seek to exit their positions, leading to a divergent trade (selling when the market is falling) and exacerbating the drawdown and resulting volatility. The next part of the loop has to do with the benchmarking of equity markets to passive indexes. As active managers tend to underperform the broad market, investors tend to pull funds from them and invest in managers who either keep up with, or outperform, markets. This has a momentum effect, where the aggregate basket of securities that the winning managers hold receives more fund flows and therefore buying pressure, leading to yet another divergent trade. Finally, in the search for yield combined with risk management, investors have increasingly turned to options markets. Covered call strategies and protective put strategies are part of many institutional portfolios with high return targets and stringent risk limits. Without delving too much into the details of it, market makers who are on the other side of these trades need to hedge their exposure by buying and selling the underlying indexes for the options. In normal times, this allows them to be providers of liquidity, but as markets experience stress and protective puts move closer to at-the-money, market makers become takers of liquidity and it becomes more costly to exit positions. When liquidity crises come to a head, the Fed has been more than happy to step in as a liquidity provider and start the cycle over again.

As investors, it may feel tempting to believe that the loop will be closed and that cascading liquidity pressures will eventually be relieved, and they very well may be. Believing this and taking more risk than one can tolerate may pay off, even if volatility is exacerbated with each loop. As with all things in financial markets, however, it’s hard to tell what will happen going forward and excess risk exposure can have disastrous results. Instead, like Corey suggests, it’s more prudent to follow the path of Icarus’s father, Daedalus, by constructing robust portfolios that are built to respond to a multitude of economic events and market environments, while still having a healthy dose of upside exposure.