After several months of low volatility across assets since mid-2016, particularly in equities, markets were more volatile last week owing to fears of central bank tightening. Volatility picked up first in FX and rates, and then spilled over to equities. However, as Goldman notes, this might not be the end of the low vol regime yet.
Via Goldman Sachs,
Since 1928, there have been 14 comparable low vol regimes for the S&P 500 – on average, they lasted nearly two years and they had a median length of 15-16 months. Often they were supported by a very favourable macro backdrop, similar to the recent ‘Goldilocks scenario’. Breaking out of the low vol regime usually required a large shock, for example a recession or war. While central bank uncertainty can drive volatility in the near term, it is unlikely to drive a sustained high vol regime.
Investors have recently started to position for higher volatility – the open interest n VIX calls has increased, inflows into the largest long VIX ETP have picked up and the net short on VIX futures has decreased. But the VIX call/put open interest ratio has little predictive power for large VIX spikes historically. We think short-dated S&P 500 put spreads best address the risk investors are facing in the near term – a consolidation but not yet a transition into a sustained higher vol regime.
However, despite the sudden reawakening of fear, Goldman is confident that this is a tempest in a teapot...
Low Vol Regime is Tested But Likely to Prevail
Since mid-2016, markets have been stuck in a low vol regime – in particular, for S&P 500, vol has been low, with 1-month realised volatility at 7% in June (11th percentile since 1928). This has been supportive for risk appetite and valuations of risky assets. But in the past few days, in part owing to fears of central bank tightening, volatility has picked up. FX and rate volatility picked up first and spilled over to equities, which have corrected from all-time highs. On Thursday last week, the VIX reached an intra-day high of 15, a level last seen only briefly in mid-May 2017 on concerns over a possible impeachment of President Trump but it reversed quickly afterwards. If we are nearing the end of the current low vol regime, this has material implications for asset allocation and specifically volatility selling strategies, which have been increasingly popular.
As we recently discussed, low vol regimes are not that unusual and can last for a long time. Since 1928, we have identified 14 episodes comparable to the current one, where realised S&P 500 volatility was generally at or below 10 and volatility spikes were usually short-lived. On average they lasted nearly two years, and the median length was 15-16 months. But there were several low vol periods in the 50s, 60s and 90s that lasted more than three years. We found the reason for those extended low vol regimes is usually a very favourable macro backdrop with strong growth but anchored inflation and rates – very similar to the market-friendly ‘Goldilocks scenario’. Since the end of January, markets have reflected a similar situation – equities have reached all-time highs with continued strong global growth while bond yields have declined during the ‘reflation pausation’.
Forecasting the end of low vol periods is unsurprisingly difficult. Historically, volatility spikes have been hard to predict as they often occur after unpredictable major geopolitical events, such as wars and terror attacks, or adverse economic or financial shocks (e.g. the Euro area crisis), and so-called ‘unknown unknowns’ (e.g. Black Monday in 1987). Recessions and a slowing business cycle have historically resulted in a high vol regime across assets. And while central banks have generally buffered volatility since the late 90s, uncertainty over central bank policies can also drive more volatility. Recession risk remains relatively low – our economists see a 25% probability for the next two years, below the unconditional probability of 33%. However, in the near term, current low bond yields increase the risk of a negative rate shock in the event of increased concerns over additional central bank tightening, which could close the gap between equities and bond yields.
Investors have recently started to position for higher volatility – the open interest in VIX calls has increased, inflows into the largest long VIX ETP (iPath S&P 500 ST future, VXX) have picked up and the net short on VIX futures has decreased. The VIX call/put ratio has spiked to one of the highest levels since the GFC, indicating investors anticipating a higher VIX.
As shown in exhibit 1, the ratio between VIX call and put open interest is now back at 2007 and 2014 highs, where realised volatility was similarly low. However, a backtest shows that it has limited predictive power for vol spikes – although there is little history (see Exhibit 2). The largest vol spikes have usually occurred from average levels of the VIX call/put open interest ratio, i.e. have not seen material positioning ahead.
While in the near term, volatility could pick up as the ‘Goldilocks scenario’ fades, it might not drive a breakout from the current low vol regime unless recession risk picks up or uncertainty on central bank policies increases on a more sustained basis. Indeed, a more plausible risk is an increase in bond term-premia from current depressed levels, as reflected in our rate forecasts. In our asset allocation, we are Neutral Equities on a 3-month horizon as we see little return potential near term and risk of a consolidation, but we stay Overweight for 12 months. For Bonds, we remain Underweight on both a 3- and 12-month horizon. We believe that in the near term, the risk/reward for vol selling strategies has worsened but find it difficult to be long the VIX owing to the high cost of carry.
As we showed previously, when low vol regimes end, they tend to do so with a small ‘risk off’ initially; usually, larger equity drawdowns have occurred only after a transition into a higher vol regime. With very steep vol term structures and high skew (the cost of OTM puts vs. calls) in equity options, we like protection through put spreads. A 97%-93% 1-month put spread on S&P 500 is now trading at 6th percentile cost based on the last 18 years and it offers a max payoff of more than 16x in case of a >7% drawdown. We think this strategy best addresses the risk that investors are facing in the near term – a consolidation but not yet a transition to a sustained higher vol regime.
Investors who buy put spreads risk a maximum loss of the premium paid.
Goldman aren't alone in their Goldilocks-iness, AQR also sees smooth un-volatile sailing ahead...
For all that's being said and written about the lack of volatility in financial markets these days, you might think something unusual is going on. In fact, history suggests it's the opposite.
The pattern is pretty clear when one considers realized 30-day volatility for the S&P 500 Index on an annualized basis going back to 1927. Every five years or so volatility rises above 20 percent for a year or two, sometimes getting much higher but usually not, and in between it sweeps out a shallow bowl-like trading pattern that bottoms at about 10 percent. That seems to be exactly what is happening now.
Those with sharp eyes might detect that the current volatility lull is a bit deeper than the previous one from 2002 – 2006, while it’s about the same as the 1990s lull as well as those in the 1950s and 1960s. So, yes, volatility is lower than average historical levels, but it’s at levels typical of the bottom of a quiet period between two crises.
It’s hard to tell from the long-term time series just how long before a crisis that market volatility starts increasing. Taking a look at the same chart since 1990 and adding in the CBOE Volatility Index, or VIX, from the beginning of the period 1 one sees that during the internet bubble both realized volatility and the VIX peaked at the end of August 1998, at 42 percent and 44 percent, a year and a half before the Nasdaq plunged. At the end of January 2000, with the crash still more than a month away, both realized volatility and the VIX were at 25 percent. Before equities tumbled in 2008 crash, the VIX had poked above 30 percent in August 2007, more than two months before the stock market peak and more than a year before the financial crisis sparked, in part, by the bankruptcy of Lehman Brothers. From the end of July 2007 to the end of July 2008, the VIX averaged 23 percent and realized volatility averaged 21 percent.
The moral? History shows that crises occur when the VIX and realized volatility are above 20 percent, and investors typically get warned months in advance of what the headlines refer to as “shocks.”
Another way to see the same point is to look at realized 30-day volatility for the S&P 500 on an annualized basis versus the VIX at the beginning of the period. The black line in the graphic below shows the level of volatility predicted by the VIX, so points above the line mean actual volatility came in above the VIX. You can see that most of the points are below the line because the VIX overestimates realized volatility. But the important thing is that there aren’t big surprises at low levels of the VIX. Realized volatility has never been above 20 percent starting from a VIX that is under 12 percent. And the really high realized volatilities are almost all starting from when the VIX is above 20 percent.
The red squares in the chart are the numbers from 2017, showing that both realized volatility and the VIX are at low levels, but not unprecedentedly low levels. Looking at what happened in the past starting from these VIX levels, it seems unlikely that we’ll get realized volatility above 20 percent at least over the next month. I’m not claiming a switch to a period of high volatility or a stock market crash is impossible. I’m saying that the evidence provides an argument that dramatic moves are unlikely anytime soon rather than a warning sign of an impending crisis.
What about all the political turmoil, the populist revolts and terrorism? By and large, the market anticipates news events about 18 months in the future. It’s not perfect, of course, but it’s a lot better than experts and commentators. It’s silly to expect today’s news headlines to affect today’s stock prices in a large way, with the exception of truly unanticipated events such as earthquakes.
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Look at the volatility spike in August 2015. Empirical evidence of the lag between stock market moves and when shifts become obvious to commentators suggests that’s about the time the market was worrying about Brexit and Marine Le Pen and Jeremy Corbyn and Donald Trump -- perhaps not specifically, but about the political trend that underlies those things -- and about other social, political and economic trends pundits are chewing over today. The market sorted that out before the first U.S. presidential primary debate, while the news reporters were focused on Ferguson, Missouri; missed debt payments in Greece and Puerto Rico; and whether Marco Rubio could outpoll Jeb Bush for the Republican nomination, with the Democratic process a forgone conclusion.
So it's simple - aside from recession (never gonna happen) or war (never gonna happen), sell the fucking rip in VIX... or as they used to say, keep picking up those nickels in front of the steam-roller, what could go wrong?