Artemis Vega Fund LP | Volatility Market Analysis | March 2016 Page 1

Artemis Vega Fund LP

Volatility Market Analysis – March 2016

Meeting of the Waters (Encontro das Aguas)

In northwest Brazil, near the town of Manaus, the two largest tributaries of the Amazon River, the Solimoes and Rio Negro,
converge in dramatic fashion in what is known as the ‘Encontro das Aguas’ or ‘Meeting of the Waters’. The Solimoes
River is light and milky in color due to receding sediment from the Andes Mountains. The Rio Negro River is dark black
derived from decaying plant matter collected in the jungle. The two rivers co-exist in vivid contrast, running side-by-side
for miles but never mixing, due to differences in temperature, speed, and water density. The ‘Meeting of the Waters’
marks the beginning of the Amazon River, one of the longest, most mythic, and dangerous rivers in the world.
The ‘Meeting of the Waters’ is also a fitting analogy for today’s market: the seven year bull market run in US equities, the
second longest in history, has now converged side-by-side with an ominous and dark tributary, leading into an unknown
future. Today’s financial market is now two markets in one, a dark bear market with significant fundamental risk, and a
light bull market buoyed by central bank interventionism and share buybacks. The daily returns of this convergence of
risk are a rare combination of positively and negatively skewed regimes. These two distinct market risk tributaries have
converged since August of last year flowing simultaneously side-by-side but never mixing. Twice over this period, the US
equity market experienced peak-to-trough drawdowns of over -10% (August to September 2015, January to February
2016) that were quickly erased by feverish buying sprees (October to November 2015, February to March 2016) instigated
by central bank intervention, share buybacks, and short covering. The whipsaw nature of risk, including some of the lowest
levels of volatility persistence on record (comparable only to 2003 and 1960s based on GARCH models), led to the worst
start to the year for active strategies in over a decade. While this market is highly unusual… it can be quantified. Rather
than navigate this ‘Meeting of Markets’ by boat, let us take to the air to see the bigger picture

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Multi-Modal Probability Distributions in the Amazon

Mathematically, when different states of the world converge but do
not mix, their characteristics can be modeled by a multimodal
probability distribution. The multimodal distribution is a mixture of
two or more probability distributions with similar variance but
different means. For example, the statistical average color of Brazil’s
‘Meeting of the Waters’ is less compelling than the extreme local color
of each tributary. The milky color of the Solimoes is one peak, and the
dark color of the Rio Negro the other.
Like the rivers, the S&P 500 index and VIX index represent a
combination of two entirely different positively and negatively skewed
market regimes. This oddity becomes apparent when we compare the
probability distributions of daily returns for each index against their
long-term historical distributions.
Two Rivers of the VIX Index

The typical distribution of daily VIX Index returns shows a pronounced peak around zero and fat right tails (representing
volatility jump risk). The recent distribution of VIX returns (July 2015 to March 2016) is a highly unusual tri-modal
distribution with three distinct means representing both up and downside shocks. The VIX is now part of two rivers co-
existing but not mixing, one skewed toward volatility spikes and tail risk, and the other skewed toward volatility declines
and market gains. When measured statistically, the skew seems normal, but when visualized it is clear that the peak of
the return distribution has been suppressed to favor a skew in both directions. While volatility has increased since 2014,
spot-volatility declines (the left of the return distribution) are occurring six times more frequently than normal at the
expense of the center of the distribution. As a result, crisis alpha opportunities have given back gains quickly, and arbitrage
inefficiencies are harder to exploit without taking directional bets. This is one reason why, quixotically, the CBOE Long
Volatility Hedge Fund Index (-2.71%) and CBOE Tail Risk Hedge Fund index (-4.48%) have both experienced losses since
July 2015 despite higher overall volatility. In historical context, this is just plain weird. In fact, the daily returns of the VIX
between July 2015 and January 2016 were the second most anomalous in history (next to 2004) when compared to any
six-month historical distribution since 1990.

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Two Rivers of the S&P 500 Index

The S&P 500 index is exhibiting much the same multi-modal peculiarity as the VIX index. To understand the dividing line
between light and dark markets look no further than the month after earnings announcements, when the SEC-mandated
share buyback blackout period officially ends. In the past two years, this period has encompassed three of the top ten
“supernormal” volatility drawdowns in history. It is no longer a secret that share buybacks are a key driver of these stock
market rallies (see Artemis’ December 2015 letter to investors for full analysis). Corporate share buybacks attributed
$165bn of stock inflows in the quarter, the highest pace since 2007, while mutual funds, ETFs, and foreign investors have
been net sellers. In essence, share buybacks are now the only buyer keeping the stock market afloat; something that
cannot continue indefinitely. Below we graph the probability distribution of S&P 500 index daily returns in the dark waters
of the buyback moratorium (August-September 2015, January to Early-Feb 2016) vs. the light water buyback periods
(October to November 2015, February to April 2016). The contrast is startling. Both the light water and dark water SPX
probability distributions are multi-modal, with the core difference being positive or negative directionality of the
secondary mode.

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The Federal Reserve has also played a major role in supporting markets, first by surprising in September 2015 with no rate
hike, and then in March 2016 with dovish guidance. Never underestimate what global central banks are capable of doing
to support stock prices and real estate – anything really - up to the point where people take to the streets with pitchforks
due to further income inequality. The risk of an extended hyper-bubble in all financialized asset is a very real possibility
given this level of institutionalized moral hazard and political aversion to another market crash. At the same time, the
credibility of central banks and their power over markets seems to be waning with each new round of stimulus, as
evidenced by hostile market reactions to recently implemented negative rates in Japan and Europe.
Light and Dark become the Amazon
Eventually even the Rio Grande and Solimoes River become one AMAZON. Something will give – the market cannot rely
on stock buybacks indefinitely absent fundamental earnings growth. Central banks from the Fed, ECB, to the BOJ are
quickly losing credibility. At these valuations in a late phase bull market there are three forms of defense that have
historically performed: 1) long volatility 2) US treasuries and; 3) cash. . As for bonds and cash - zero to negative yields is
starting to do more to cause volatility than prevent it - and this creates risk in both these traditional safe havens. The cure
has become the disease… keep that in mind as we float down two merging rivers into an uncertain and dark jungle.

Christopher R. Cole, CFA

Artemis Capital Management LP
Artemis Vega Fund LP
98 San Jacinto Blvd. Suite 370
Austin, TX 78701
Notes: Special thanks to Michael Holmes, PhD – Artemis VP of research – for suggesting the “Meeting of Rivers”
analogy. Michael spent two years in Northern Brazil and speaks fluent Portuguese in addition to many other talents
relevant to volatility trading. Images from Reddit and Wikipedia. Data from Bloomberg and Artemis Capital.

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The Partnership’s success depends on the General Partner’s ability to implement its investment strategy. Any factor that would make it more difficult to execute timely
trades, such as a significant lessening of liquidity in a particular market, may also be detrimental to profitability. No assurance can be given that the investment
strategies to be used by the Partnership will be successful under all or any market conditions.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT
ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN
HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF
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EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN
ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION
OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF
WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

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implement its investment strategy. Any factor that would make it more difficult to execute timely trades, such as a significant lessening of liquidity in a particular
market, may also be detrimental to profitability. No assurance can be given that the investment strategies to be used by the Partnership will be successful under all or
any market conditions. This is not an offering or the solicitation of an offer to purchase an interest in Artemis Vega Fund, L.P. (The Partnership). Any such offer or
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indicative of future returns.

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