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What Even is a Volatility Trap and Are We in One?

Tuesday, May 03, 2022 02:41 PM | Neal Farmer

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What Even is a Volatility Trap and Are We in One?

Rapid inflation followed by tightening of monetary policy has pushed many investors out of the market.

Surging coronavirus cases in China and a Ukrainian-Russian war that has led to massive sanctions against Russia for its actions have also not helped matters economically. Add to that continued supply chain disruptions and shortages and volatility in markets keeps rising.

What is a Volatility Trap?

All those factors aren’t exactly what could be causing a volatility trap but instead are the precursors to one. Higher volatility in markets discourages investments, which then leads to higher volatility, thus, leading to more discouragement of investments and on and on it goes.

People don’t want to invest in extremely risky markets unless the reward is high enough to outweigh that risk. The problem is that this isn’t a Dogecoin (DOGE) or GameStop (GME) situation where it's pure gambling. Instead, there are real economic and diplomatic situations that determine if the reward is worth the high volatility. All the factors mentioned above such as rising inflation and the need for tighter monetary policy don’t exactly help push markets higher.

The Whole Market

The entire stock market is experiencing some degree of a volatility trap where recent losses have pushed investors out of the market, thus, leading to even stronger selloffs and increased volatility. This is far from unheard of, or unseen, in the stock market as once a stock starts to lose value it causes others to panic and sell their shares to minimize losses. That reaction is sometimes reasonable but often backfires when the same rebounds the same day or shortly after and the investor buys back in at a higher price than they sold for.

Attempting to beat or time the market is nearly impossible which is why the best investors often simply buy-and-hold over the long term. This is why esteemed investor Warren Buffet has said, “Our favorite holding period is forever” and that “if you don't feel comfortable owning a stock for 10 years, you shouldn't own it for 10 minutes”.

The whole market may be in a bit of a trap for now but it will recover and set new highs again in less time than most probably expect. Those looking to invest for the long-term to help with retirement or other goals shouldn’t be overly worried over a bump in the road here and there. Just because Apple (AAPL) and Amazon (AMZN) are down big this year doesn’t mean they’re bad long-term investments, in fact it represents a great buying opportunity to get in before they almost surely recover.

More important understanding exactly which assets are in a volatility trap right now and trying to determine when it make end.

Who is in a Trap?

It’s no secret that commodity prices have surged since the pandemic as demand rose faster than expected and supply wasn’t able to keep up. Recent coronavirus case surges in China forced the country to again shut down production in several factories, further exacerbating  supply chain problems.

Despite the massive rise in commodity prices, investments in new production have been lagging. Goldman Sachs Head of Commodities Research Jeff Currie has been forecasting a commodities supercycle since 2021 as investors will be wary to fund new productions as the outlook remains uncertain and government policies aren’t currently smoothing prices. Investment in commodity production is what’s needed to resolve shortages and price hikes.

One of the big problems is that the financing isn’t readily available. Currie argues that this is partly occurring due to a revenge of the old economy with the recent pushes for ESG investments that have left traditional industries such as oil and gas or metals and mining shunned. Even banks are affected due  pushes for ESG investments with people looking for cleaner and renewable sources of energy that simply do not have the current infrastructure that the “old economy” industries do.

The problem is only amplified by the fact that oil companies aren’t using profits to increase production but instead are returning cash to shareholders. More investment in commodity production is simply needed to resolve the shortage and that is not happening at the scale needed.

The trap comes into play with price volatility discouraging private-sector investment, while inflation worries keep potential government funds to a minimum.

Wrapping Up

Markets are experiencing some degree of a volatility trap currently and looming tighter monetary policy is not doing much to push for more investments. Meanwhile, commodity prices remain far above where they were just three years ago as shortages continue and economic conditions are limiting the investment in new production. A re-embracing of the old economy is likely what is needed to help fuel investments in new production that will lower prices and help fight against high inflation.

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