The Harder They Come, The Harder They'll Fall...
Markets are remarkably schizophrenic about where risk is flowing... and where it isn’t. For example, ConvergEx's Nick Colas notes, the CBOE VIX Index is up from 12.3 a month ago to a close of 14.0 yesterday. And other risk assets such as Emerging Markets, U.S. Small Caps, Energy names, and developed economy international stocks all show higher 'VIXs' over the same 30 day period. But... and it’s a big 'But'... just as many sectors/asset classes in our tracking universe show declines in their 'VIXs'. The most pronounced are domestic Consumer Discretionary, Utilities, and Tech names as well as precious metals and High Yield Corporate bonds, where Implied Vols are 6-17% lower this month and in most cases are at/near 52 week lows. If you are looking for spots where volatility might make a comeback, these are good places to start.
This market reminds us of an old joke:
Question: What do you call a person who is both ignorant and apathetic?
Answer: I don’t know and I don’t care.
Via Nick Colas, ConvergEx:
That little joke could easily describe the state of both cash equities and listed options at the moment. Just look at the last few trading days. You have a Eurozone country – tiny Cyprus, rich with supposedly illicit Russian cash, evidently – threaten to tax depositors as part of a financial system bailout package. Only the most plugged in market observers even had a whiff this was coming just a week ago. It is a monumentally bad idea, if only because the safety of deposits is a cornerstone concept in modern banking. It reminds me of an old Woody Allen line from Love and Death: “If it turns out that there is a God, I don’t think that he’s evil. I think the worst you can say about him is that basically he’s an underachiever.”
And yet despite this unexpected and unsound policy step, global markets have not taken the bait into a fresh round of panicky selling, as they have so many times over the past four years. The CBOE VIX Index can’t seem to hold 15, quite a distance from its long run average of 20. Stocks sold off early in the trading day, only to catch a bid at levels above yesterday’s lows. The Dow actually closed up on the day. Yes, it might be that investors will regret not taking the easy out in coming days. The old trading floor aphorism, “Instead of yelling, you should be selling” may yet prove correct.
But peel back the volatility “Onion” a few layers, and you’ll find that markets aren’t quite as sleepy as the last few days might indicate. Every month we borrow a page from the options pricing world and look at the changes in Implied Volatility for a host of asset classes and industry sectors. Those measurements are essentially the “VIX of” everything from gold and silver to tech stocks and emerging market equities. By looking at the listed options pricing for a range of Exchange Traded Funds which track these investments, we can watch the ebbs and flows of risk perceptions across disparate asset types and sectors. There are a few graphs immediately after this note, but here is a summary of our findings:
- Several asset types have followed the CBOE VIX Index higher over the past month. Emerging Markets “VIX” is up 17% over the same period. The Implied Volatility of domestic Small Cap Stocks is up 7%. The “VIX” for developed economy foreign stocks, as measured by the Europe/Asia/Far East (EAFE) index, is likewise 6% higher over the past 30 days. Among industry sectors, the “VIX” for Energy names is up the most (+7%), followed by U.S. Material stocks (+5%) and Consumer Staples, Industrials, and Health Care equity “VIX” (+1-3%).
- Just as many of the asset types/sectors where we follow monthly changes in Implied Volatility have shown a decline in their “VIX” as those where that measure has increased. The score is 9 down, 9 up, and one essentially unchanged. That is an odd setup, given that 16 of these investment types saw positive returns over the last month. In general, Implied Volatility and returns are supposed to be inversely correlated. This month, not so much…
- The “Biggest Losers” in terms of Implied Volatility this month were U.S. High Yield Corporate bonds (down 17%), gold/silver (down 11-12%), and then U.S. Consumer Discretionary, Utilities, and Tech stocks (down 6-9%). The only two that broke significantly from the usual Implied Vol/return relationship were the precious metals, with gold essentially unchanged on the month and silver down 3%.
The rhyme and reason behind these moves is hard to tease out, so let’s conclude by focusing on the true anomalies – the new lows for the “VIX of” our sample universe. Three assets pop out based on that parameter:
- High Yield Bonds. The “VIX of” this asset class is stumbling along at/near new lows despite worries about “Junk” bonds as a dangerous parking lot for yield-hungry cash. Historical volatility is clearly the anchor here, with this asset class virtually somnambulant over the past 10/20/30 days. Look deeper into the history of this asset class, however, and you’ll see that it more often trades like equity than it does a reliable payer of coupons. The sleepy Implied Vols here are a clear – and dangerous – anomaly.
- Gold and Silver: The biggest “Tell” (at least to my eye) that no one is truly worried about Cyprus is the fact that gold and silver haven’t ripped higher. Now maybe we’ve entered a new phase in social history where gold is no longer valued during periods of social duress and questions over fiat currency. I doubt it, however, since it would be the first such event since the advent of writing. About 5,000 years ago. The “VIX of” gold hovers at one year lows, and the historical volatility is pretty dead as well. As of Monday, 10 day volatility was 7% and down from the 30 day volatility of 13%. Silver’s story is much the same.
I think the only logical conclusion to the data here, full of oddball inconsistencies, is that we are simply treading water in both stock and equity markets. My bias is to believe that the strength of the tape over the last few days indicates we are going to have a pretty positive close to month. The lack of real interest on the part of the options market to bid up the cost of insurance (Implied Volatility) may not fit neatly into a bullish argument, but this is (for the moment) the hand we’ve been dealt. Shaking the market of its complacency – that sub-15 VIX, for example – isn’t going to be easy. And over the near term, the path to the upside is both easier and increasingly contrarian. And how often do you get that combination?
Enjoy it while you can.