Low Volatility Will Make The Next 5% Drop In The Dow "Feel Like 1987"

The VIX has recently flirted with its all-time closing low, analysts worry that volatility has been so low for so long that analysts are worried that the next sizable negative shock will cause investors to panic and dump their holdings.

Other than a handful of selloffs over the past couple of years (Aug. 2015, Jan. 2016, June 2016), Federal Reserve-led easing has guided markets steadily higher since the crisis. As MarketWatch reports, The Dow hasn’t experienced a 5% drop since 2011, and before that a 5% drop hadn’t happened since 2008, when there were 9 such drops. The blue-chip index closed at a record high on Friday, leaving it just 200 points shy of 22,000. At this level, a 5% selloff would equate to a 1,100-point, one-day slide in the gauge - an eye-popping four-digit drop.

Art Hogan, chief market strategist at Wunderlich Securities, says the market isn’t prepared for a large selloff because "garden-variety" volatility has been largely absent from US stocks for the last year.

"'I would say no because we’re out of practice. Your usual standard garden-variety volatility just hasn’t been around, and we haven’t seen it for 12 months,' Hogan told MarketWatch.

 

'Quiet markets have been the norm and not the exception and I think a major pullback is going to feel a whole lot larger for lack of experience and the numbers are larger,' he said.”

Hogan isn’t the first strategist to point out the market’s vulnerability to a sharp rise in the VIX. As Morgan Stanley’s Chris Metli said in a research note exploring what a “short vol unwind” might look like. Low volatility has produced a regime where the risks are asymmetric and negatively convex, so being prepared for an unwind is critical, since a 3% or 4% move in the S&P 500 can have a disproportionately large impact on the VIX as dealers and exchange-traded products rush to hedge.

According to Marketwatch and Dow Jones data, even a 2.5% drop in the Dow, adding up a 550-point decline, could rattle investors. Moves of this magnitude, while still relatively rare, are far more frequent, with 564 such moves occurring in the Dow since 1901. The most recent slump of this magnitude occurred on June 24, the day after the Brexit vote, when the Dow tumbled about 610 points, or 3.4%. There were three such moves in 2015. The S&P 500 is also long overdue for a major pullback.

As for the S&P 500, 61 of the past 67 years have seen at least one 5% drop, or 91% of all years, according to Ryan Detrick, senior market strategist, at LPL Financial.

"‘The inevitable 5% drop will be a shock to nearly everyone,’ Detrick said. ‘We’ve been historically spoiled so far this year, but as the economic cycle ages, we fully expect more volatility the remainder of this year and the likely 5% correction to take place as well,’ he said.”

Still, it’s important for investors to remember that while a 5% might “feel like 1987,” it’s necessary to “flush out the weak hands,” Detrick says.

“The important thing to remember is the Fed is still accommodative, earnings continue to improve globally, and inflation is contained - meaning any pullback could be a nice opportunity to add equity exposure.

 

Although a 5% correction might feel like 1987 to some of us about now, pullbacks and volatility are perfectly normal parts of bull markets and are needed to flush out the weak hands.

Market luminaries including billionaire investor Howard Marks and Nobel Laureate Robert Shiller have warned investors to be cautious. According to Shiller’s CAPE ratio, a popular measure of equity valuations, S&P 500 valuations are at levels only seen twice before: in 1929 and 2000. Shiller said on CNBC Thursday that he “lies awake worrying” about how long this period of quiet will last. Doubleline Capital founder Jeff Gundlach said his fund bought up VIX calls when the index hit its most recent lows.

To be sure, investors are willing to pay a premium for protection. According to Bank of America, the market has never "trusted" the VIX as little as it does now, and has never before been willing to pay, and bet, more for upcoming imminent sharp moves.

Comments

johngaltfla Sanity Bear Mon, 07/31/2017 - 05:21 Permalink

Tyler, the next 5% drop won't be noticed because the first 10% drop will happen in the dark without the public sheeple having a clue about it. Because of the structure of trading now, the masses won't realize the train has hit them until it is too late. Only the geeks like us hanging here and elsewhere will know of the majority of the crash and when/if the markets do open, the NYSE circuirt breakers will have the unintended consequences of causing more, not less panic.Like I said just a while ago:The Next Market Crash Will Not be Televised

In reply to by Sanity Bear

wide angle tree Mon, 07/31/2017 - 04:30 Permalink

The markets are just another policy tool for the CBs now. There is no risk and possibly no reward. Your return is now decided by committees of overeducated shitheads.   

gregga777 Mon, 07/31/2017 - 04:31 Permalink

A drop of 50% would be well worth it if we are treated to lots of banking gangsters and CON Street Swindlers jumping out of at least 10th floor windows.

Haus-Targaryen buzzsaw99 Mon, 07/31/2017 - 04:55 Permalink

I thought about commenting on this article, but I couldn't sum up my thoughts into something coherent.  Thank you for doing it more eloquently than I could have.  You're right, actually.  For the majority of Americans this valuation has no bearing or meaning.  Some 10% of American households are invested in equities and of that group, I'd venture to say most think its "going up forever".  The thought of a correction or a return to fair value is almost incomprehensible for the average person, thus the only people that really care about this metric are three groups of people:1) People who manage money2) Politicians and central bankers who use this metric to placate the population3) People like us who want the S&P to go to zero. Apart from that, you're right.  No one cares.  

In reply to by buzzsaw99

hibou-Owl Mon, 07/31/2017 - 04:55 Permalink

I made money in '87 correction, (at uni sold the lot and more the thursday before, I still have the contract notes from Young & Co).

Bring it on, time for another clean out. Limit down for a fortnight.

ludwigvmises Mon, 07/31/2017 - 04:57 Permalink

Wait so I can't keep selling 5% OTM sp500 puts w/ $5k margin per futures contract? This "strategy" has been paying my bills so far with no risk at all. Free money.

mily Mon, 07/31/2017 - 05:09 Permalink

IMHO it is a perfect time for a vix spike as lack of vol encourages to lever up to make up for relatively small market moves (or to sell options to cash out premiums), combined with low cash balances this could be a recipe for a sudden vix spike a'la aug 2015

lester1 Mon, 07/31/2017 - 05:46 Permalink

1987 we didn't have the Federal Reserve's Plunge Protection Team covertly buying stocks either. Ceep calm ,PPT will keep everything propped up until the Fed gets fully audited !

Let it Go Mon, 07/31/2017 - 06:10 Permalink

Markets appear stable, however, being invested is always a risk. Most investors think that even if things go downhill fast that they will be smart enough to get out of the markets. After the debacle in 2008 where they saw the market take nasty and violent swings they learned a few things, this time, they figure they will make the right moves before it is too late. But what if it hits like the flash crash on steroids?Imagine a scenario where the if the market falls like a flash are trapped. They have been assured that can't happen because circuit breakers have been put in place to arrest panic style moves but if trade is halted, and the market simply does not reopen for days or even weeks suddenly it is a new game. As remote as this might seem the article below explores this possibility and the far-reaching ramifications. http://brucewilds.blogspot.com/2016/08/flash-crash-on-steroids-makes.html

J J Pettigrew Mon, 07/31/2017 - 06:20 Permalink

The Fed has self authored their mission statement..iron out all cycles, market gyrations ...but, in so doing, theoriticians such as Janet and Ben display their entire lack of faith in FREE MARKETS and their ignoranceof the fact that cycles and swings wring excesses out of markets......what Ben and Janet have done is create excesses, misallocations of resources and over leveraging

Last of the Mi… Mon, 07/31/2017 - 06:59 Permalink

 No, asshole, trillions is derivatives and unfunded liabilities will make the next 5% drop seem like 1987! These guys couldn't report the truth if it fell out of their favorite hookers' twat etched on stone tablets. I mean damn!