Hidden Cracks: A Market Primed for Volatility Spikes
- The month of May has proven to be an interesting month for Global Markets; on the 17th of May, the CBOE Volatility Index (VIX) spiked 46% on news of Trump’s entanglements with Russia. On concerns over Trump’s continued ability to enact meaningful tax and regulatory reform, the Dow and the S&P plummeted 1.78% and 1.82% respectively – their worst performing days since September of last year.
- Although market movements like this have certainly happened before, what is interesting about this episode is that it demonstrates how little volatility is priced into the current market. As was mentioned in previous outlooks, market participants appear to be unusually optimistic about fundamental growth in the economy, when there has been very little evidence (either in tangible reform or in hard data) to support this thesis.
- Take, for example, Q1 GDP Growth in the U.S. which came it at 0.5%. Personal Consumption is equivalently at 0.3%. And add to that further headwinds in U.S. Retail and Auto Sales, both of which have experienced significant contractions since last year. Yet, the U.S. Michigan Consumer Sentiment Index, which is taken as a proxy for consumer confidence in the market, remains at all-time highs, in the 97.1 region. (As seen in chart 1)
- So, what we appear to have right now is a market with propped up levels of confidence and extremely suppressed levels of volatility. This, however, is contrary to the anemic growth in hard economic data and hides serious frailties in the economic system. More importantly, as we can see from the incident on May 17, the potential for geopolitical risks to elicit extreme market moves remains high.
- How then, can we take advantage of this highly unusual market environment? One investment idea that we could consider is to be long on volatility, which may be expressed either through specialized “Volatility ETFs” that track the VIX, or via option contracts on broad-based market indices like the S&P500. Since the downside risk is limited to the option premium on these contracts, while the upside is uncapped, a trade like this may prove to have superior risk-return profiles than traditional bets on equity markets, which are trading at historically high valuations.
- Since May 17, we have seen a quick retracement of the VIX Index to 9.81, virtually unchanged from levels prior to the Trump spike. This could offer us an opportunity to position ourselves profitably over the long-term, by betting that such suppressed volatility will eventually correct itself.