April 11th, 2018
U.S. markets have had a rough start to the new year. Although the S&P 500 is only down around 2% since the beginning of January, current uncertain investor sentiment is in stark contrast to the optimism fueled by cheap credit and growing earnings over the past two years. It appears markets have hit a snag. Much of the dialogue surrounding explanations of why and how the upward trend has faltered is centered around volatility. Just a few months prior, debate circled around rationalizations for historically low measures of volatility. Now investors are concerned about why volatility is back and whether it is truly elevated in a typical sense at all. Through analysis of the VIX and its deeper-tier volatility tracker the VVIX it can be shown that some volatility is a positive force in the markets and that the S&P 500 is highly unlikely to recover its dramatic upward trend.
The easiest question to answer is perhaps the one most frequently asked. No, volatility is not exceptionally high. As shown by a long-term outlook of the VIX as published by the Chicago Board Options Exchange in Figure 2, within the realm of historical measurements of volatility the VIX pushing past 20 is relatively unremarkable. It is only scores of 30 or greater that push the envelope of unexpected market movements. However, it is important to note that volatility is a non-directional indicator in markets. High volatility levels don’t mean falling markets, as shown by an increase in both volatility and market value in the mid to late 1990s. A more important indicator for our analysis of current market trends is the VVIX.
Published by the CBOE, the VVIX presents a tool to understand volatility, a direction independent indicator, and its complex relationship with directional market forces. It is important to note that the VVIX is also a forward-looking indicator, displaying the expected 30-day forward price of the VIX. It is a volatility measurement of volatility. A 6-month chart of the VVIX gives a relevant example of its purpose. As the market meltup broke at the start of 2018 and volatility increased, investors feared further increases in volatility itself, pushing up the VVIX. Worryingly, the VVIX has since collapsed, meaning that investors no longer expect dramatic further shocks to volatility within the near future. The reason this is a problem is that it signifies a gradual acceptance and complacency of current volatility rates. Diving deeper, this means over the course of the past several months both institutional and retail investors have bought into the idea of current market movements which have since been horizontal at best and potentially downward sloping depending on the time frame. If expected future volatility is low or current slightly elevated rates are accepted, then investors are less likely to flinch when hit with a daily drop. It is a bottom-up approach that means lower future volatility based on purveying investor sentiment and as such, steadier future market trends in the near-term.
The question then becomes, what new regime is beginning to take hold in the markets? Has the buy-the-dip mentality been reaffirmed, has a sideways trend been accepted, or are we watching the beginning of a deep bear market? Unfortunately for those long on the market, the S&P seems to be establishing itself as a long-term slightly downward sloping bear. The reason for this is simple, all positive news has already been factored into the market. This means that there is a high probability that any new information is going to be exclusively negative. Within the next year this could come from a variety of sources including a continued trade war escalation between the U.S. and other countries specifically China, an unexpected inflation jump, and an increase in the projected budget deficit as a result of policies enacted or supported by the Trump administration. Even without these factors, the front end of the yield curve continues to push upward, with the one-month U.S. overnight indexed swap rate already showing a slight inversion. As short-term borrowing costs creep higher, the equity markets are likely to take a serious hit. Given these factors, there is only a 30% chance the S&P 500 will break its high of 2,872.87 by the end of 2018 and a 50% probability it will end the year between 2,400 and 2,800. There is a 20% probability it will drop to between 2,000 and 2,400. After all, as shown by the Street’s recent turn on FAANG stocks, the poster children of the post-crisis boom, prices are not set by fundamentals, but non-rational actors in an imperfect system.
In order to effectively take advantage of these forthcoming market developments it is time to become more selective. Stay out of volatility plays because the premiums associated are still too high for expected payoffs given an uncertain timeframe. However, also don’t completely rebalance your portfolio by selling out of equities and entering into bonds. Instead it is time to pick up financials in the corporate equity market as they tend to benefit under higher-rate regimes. Also wait for a full inversion of the yield curve before looking for a play into debt markets. There is typically a lag after a full inversion until equity markets respond. There may also still be some time before equities determine a direction. This wait will prove beneficial as it will allow time for more certainty around Fed decisions related to rate hikes with respect to inflation. Prudent investors should wait to make major decisions until they have a more secure understanding of the new Fed Chairman Jerome Powell’s strategy.