In the latest delightful note from serious "non-tinfoil" sources confirming just how broken the market has become (and how right all those who said central banking and HFT would eventually break it), Bank of America's vol expert Benjamin Bowler and team just released a report titled with the self-explanatory "While not obvious on the surface, these markets are very weird."
Actually, for anyone who has traded these markets in the "before" and "after" central planning phases, it is all too obvious just how weird the markets have become.
For the benefit of all other 17-year-old hedge fund managers and 24-year-old math PhD quants, what BofA finds striking is that "last week’s sudden shock to US equities, and rapid rebound, yet again demonstrated the historically unusual tendency for markets to jump quickly from calm to stress and back (“fragility”)."
BofA's peeve with the market's "Buy-The-Dip" reflex is hardly new, and was first pointed out by Bowler in mid-March, when the strategist lamented that "perversely, US equity sell-offs have seemingly become embraced as alpha (i.e., buy-the-dip) opportunities instead of being feared as bona fide risk-off events, as the central bank put has become a self-fulfilling prophecy."
Two months later, it's more of the same as BofA notes that the -1.8% drop in the S&P 500 on 17-May was a five standard deviation (5-sigma) event vs. trailing volatility, the third such outsized drawdown in stocks in less than a year, but only the 18th since 1928.
What is more surprising is that the sudden air pocket was immediately followed by the second-fastest retracement of a 5-sigma drop since 1928, illustrating the power of today’s “buy the dip” mindset. And while some, such as Deutsche Bank most recently, have called the market's apparent invincibility a function of the "Trump put" which has allegedly replaced the "Fed put", to BofA there is something bigger in play:
The fact it occurred in the face of risks to Trump’s policy agenda illustrates that today’s Pavlov buy the dip is not a Trump put, but something more powerful. The sudden jolt to US equities also catalysed record spikes in vol of vol and SPX skew last week. For those concerned that Trump’s policy agenda may be diluted, delayed, or possibly defeated in the coming months and catalyse a grind lower in stocks, we like leveraging steep skew via SPX put spreads and down & out puts as hedges.
Is that really the weirdest thing about the market?
Hardly: we have spent the better part of the past 8 years showing and documenting precisely that - bizarre market outlier events, and in this particular case, the market's insta-rebound response has been repeatedly documented by JPM's Marco Kolanovic, who has shown how progressively shorter the half-life of every selloff has become. However, we find it useful that more "professionals" not only observe but quietly complain against what is clearly an artifact of a broken market structure: after all that may be the only way something ever changes.
Here are some additional observations from BofA, which is clearly fascinated with the "Third 5-sigma SPX drawdown in <1yr followed by 2nd-fastest retracement in history"
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Last Wednesday’s (17-May) sudden shock to US equities, and the ensuing rapid rebound, provides the latest illustration of the capacity for markets to jump extraordinarily quickly from states of calm to stress and back – a dynamic we called market “fragility” in our 2016 Outlook. Consider that:
- Prior to the -1.8% drawdown in the S&P 500 on 17-May, the realized volatility of the S&P had been 5.7% (36bps daily vol).1 Hence the equity decline, while not large nominally, was in fact a five standard deviation (5-sigma) event (1.8% / 0.36%) when accounting for how low volatility was prior to the shock (Chart 7).
- The last such 5-sigma event occurred on 9-Sep-16, when stocks were jolted out of their summer lull by weakness in bond markets, and prior to that on 24-Jun-16 following the Brexit vote (Chart 7). In other words, the past 229 trading days have delivered three 5-sigma drawdowns in the S&P 500 (1.3% frequency of occurrence). In contrast, the prior 22,222 trading days (i.e., since Jan 1928) witnessed only 15 such drawdowns – a frequency of 0.07%, or 19x less frequent.
- Perhaps even more remarkable than the capacity for US equities to jump from calm to stress today is their ability to revert astoundingly quickly back to a state of calm. Chart 8 shows that in the three trading days since 17-May, the S&P 500 has recouped 85% of its 1.8% decline. This is the second-fastest retracement of a 5-sigma drawdown in the history of the S&P 500 and not dissimilar from the speed of recovery seen both after Brexit and in Sep-16.
- These records underscore our view that market shocks have come to be viewed by investors as alpha opportunities rather than marking the onset of rising uncertainty. Initially, a clearly visible and high strike Fed put taught the market to “buy the dip”; now, however, this behaviour has simply become a learned response function.
Sudden jolt to US equities led to record rise in vol of vol and SPX skew In equity volatility, the effects of the outsized drop in US equities on 17-May were profoundly felt in skew and vol of vol. VVIX, which measures the implied volatility of 1M VIX options, experienced its largest one day rise (34.7 points) since Feb-07 (not coincidentally another 5-sigma shock to US equities). S&P 500 3M implied volatility skew experienced the largest rise in stress among GFSI’s 43 sub-components by a factor of nearly 2x (Chart 9) and a 99.8th percentile rise relative to its own history since 2000 (Chart 10).
While S&P skew has receded from the extremes reached on 17-May, it remains historically elevated, particularly on the put side where the ratio of 10-delta to 35-delta SPX 3M put premiums (as one example) reached a 10yr+ high on 17-May and ended last week in the 97th percentile based on daily data since May-07 (Chart 11).
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And as a bonus, here are some "notable trends and dislocations" from BofA observed in the aftermath of last week's events:
Last week brought a spike in vol amid a potential political scandal unfolding in Washington. On May 17th (last Wednesday), former FBI Director Comey released a memo indicating that President Trump may have tried to influence the Flynn investigation, sending markets to sell off—the S&P declined 1.8% (the largest single-day drop since September 2016), and the VIX jumped 4.94 vol points to 15.59, the largest since Brexit. Vol-of-vol was bid and the move was outsized relative to the move in vol (Chart 17). However, by the end of the week investors bought the dip, and the S&P 500 closed only 0.38% lower while the VIX retreated to 12.04 (by Monday’s close, the VIX was all the way down to 10.93). Major US indices ended the week lower as the Russell 2K recorded the largest decline (-1.12%), followed by the Nasdaq (-0.62%), and the Dow (-0.44%).
- Markets sold off on Wed, 17-May, following reports of a memo from former FBI Director Comey that says Trump asked him to stop the investigation of former national security advisor Flynn.
- The VIX 1M constant maturity future rose 2.17 vol points to 14.24 and vol of vol (VVIX) rose disproportionately higher by 34.72 points in an unprecedented relative move.
- Similar to post-Brexit, the buy-the-dip mentality kicked in and VVIX quickly reverted ending the week virtually unchanged, only 4.7 points (5.7%) higher than the previous Friday.
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Last Wednesday (17-May), the VIX 1M constant maturity future rose 2.17 vol points vs. a -1.8% decline in the S&P 500. This beta of -1.2 was outsized relative to the -0.66 beta typically observed.
One non-fundamental factor that likely helped amplify the move higher in VIX futures was end-of-day rebalancing needs of levered and inverse VIX ETPs, whose gross vega outstanding stood at ~$200mn prior to the 17th. Indeed, our estimates suggest there was ~$48mn vega to buy on the 17th from these products’ rebalancing flows.
While this is an optically large amount of vega to put through the market, we would stress that VIX futures recorded one of their highest volume days in history on the 17th, with the front two contracts alone trading $410mn vega. Hence rebalancing flows constituted only 11.6% of the front two VIX futures’ volume, well within the bounds observed historically.
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- On 15-Aug-71 Nixon introduced his new economic plan and set the beginning of the end of the fixed exchange rates established at the end of World War II. The dollar was effectively devalued, which prompted OPEC to raise oil prices 160%, causing inflation to spike. Coincidentally, the unemployment rate soared as the FED tightened to fight inflation. As with all macro-economic policies, it took time for this to trickle down to the real economy. The GDP growth rate was above 5% in 1972 and in 1973. It subsequently dropped to -0.5% in 1974. Today’s economic environment is obviously quite different from the early 70’s.
- Nixon served his first mandate as President of the United States from Jan-69 to Jan-73. The height of the Watergate scandal was between 8-Jan-73 (days prior to Nixon’s second inauguration when five defendants in the burglary trials pled guilty) and 9-Aug-74 when Nixon resigned the presidency to then Vice President Gerald Ford (white area on chart).
- Throughout the period, S&P 500 lost over 40% of its market cap however the economic backdrop prior to the scandal was a large contributor to the decline. Realized vol trended higher and the period was characterized by three major volatility spikes, which coincided with dissemination of information on the Watergate scandal (Chart 19). Interestingly however, each vol spike reverted to the trend within on average 24 sessions.