The Clustering Effect
AdamG over at SMB Capital has a great post about market volatility and how it tends to cluster. It shows how the assumption that the markets take a "random walk" is fair only until the walker stubs his toe on a tree root. He talks about heteroskedastic modeling and how volatility events can be traded. It fits with SMB's philosphy of Stocks in Play; however, the main point I want you to get out of is that volatility begets volatility.
Multi Asset Vol
Now I want to build on and extend that overall thesis. If you've ever watched my show on Saturday (and you can view the latest one here), I go over many different asset classes during the first half hour. And while I don't necessarily trade all of these assets, they definitely do have an impact on equities. For example, we've seen over the past year that whenever the dollar goes down, the equities market tends to go up. Another example is that when the forex carry trade is doing well, that signals strong global growth and it is good for commodities and equities.
But that only has to do with direction. There is another component, volatility-- and as we can see in single market volatility, it tends to cluster. But in many cases, volatility will trickle down. And so when we see one asset class go "stupid," it often leads to butterfly effects in equities.
Why This happens
This makes sense when we consider the human element and how accounts are managed. If you have a fund that is running a global macro book and they're short gold, they've been hurt pretty hard. If they're forced to cover, they will most likely have to raise cash from other assets to get a little more even. So you may see a big buy program come in GLD and a big sell program come in TLT (assuming they were playing the deflation trade).
We also saw this back during the crash in 2008. If you look back at some of the major currency crosses, they really started to break down at the beginning of August '08. And while equities had seen some serious vol, the "crash" didn't really start until a month or two later. The volatility in the carry trade helped to bring in more vol in equities as funds unwinding their forex positions led to further headwinds.
So even if you don't trade bonds or commodities or forex, it's still very important to monitor how "nicely" they are trading, because if vol comes through in one asset, it is likely to permeate into others.
Uh-Oh.
Why am I writing this post? Because I'm looking at the vol coming into silver, cotton, sugar, and municipal bonds as a warning sign. If we see a little more panic and volatility, traders will close those positions, leading to more selling, and it will have an effect on the Great Liquidity Conveyor Belt.