Traders focus on volatility

By David Morrison  |  06/02/2018 16:55

This article looks at the US stock market sell-off in light of the short-volatility trade

Dow suffers biggest ever points loss

The equity market sell-off that began in the US continued through the Asian Pacific session overnight and carried on into the European open. Not only that, but US stock index futures were all sharply lower again ahead of Tuesday’s US open adding to last night’s substantial losses. Yesterday the Dow posted its biggest ever one-day loss in points terms while the S&P fell over 4% to record its worst day since June 2016.

Equities hit air pocket

The size of the sell-off has shocked many investors coming as it has on the back of what appeared to be a never-ending stock market rally. But there’s been an element of markets losing touch with reality – particularly since the beginning of this year – and what we’re experiencing now is the major indices hitting the equivalent of an air pocket.

What now?

Of course, the question is: what now? The attitude of the vast majority of analysts is “don’t panic – this is only a correction, so use it as a buying opportunity.” Well that seems reasonable on the surface. After all, buying the dips has proved to be a solid way to make money in the past, so why not now?

Volatility begets volatility

Well one reason may be the breakdown in the leveraged short volatility trade. This is where investors have bet on stock market volatility continuing to decline as global equities hit fresh record highs. Investors and speculators have increasingly employed leverage to get more gearing on this trade which is essentially self-reflexive in nature. That’s to say that betting that volatility will fall actually helps to suppress volatility. Now that trade is unravelling at breath-taking speed. The VIX Index (essentially a measure of short-term US stock market volatility) has more than doubled since Friday on yesterday’s fall of little more than 4% on the S&P500. This spike in volatility has triggering a plunge in equity prices.

Short volatility

Now there is an enormous amount of derivatives linked to stock market volatility. Analysts at Artemis Capital calculate that there could be as much as $2 trillion-worth of funds invested in financial products designed to profit from declining volatility. The danger is that as unhedged sellers of volatility are hit with margin calls, they are forced to liquidate other assets. This in turn would put further selling pressure on equities. However, there is a view which has circulated this morning saying that most of this short volatility trade has already been worked through. This suggests that the worst of the sell-off in equities is done. But other analysts reckon that it's too early to call a bottom to the current move and that investors should hold back in case there’s another surge in volatility later today.

Bond yields pull back

Something else to consider is the reaction of the bond market, specifically US Treasuries. The rally in equities was already beginning to splutter at the beginning of last week. The catalyst for a touch of trimming of stock market exposure was the pick-up in bond yields (or rising borrowing costs) and the corresponding move lower in bond prices. This saw the yield on the key 10-year note break above 2.5%, then 2.63% (hugely significant levels according to bind market gurus Bill Gross and Jeff Gundlach) before they surged to 2.88% (their highest level in four years) on Friday. But while equities melted down yesterday, there was a move back into bonds which saw the yield on the 10-year pull back below 2.65% at one stage. Now, this tells us a number of things. Firstly, investors were desperate to find a safe haven away from equities, so pushed money back into bonds. But secondly, yields are still above levels that both Bill Gross and Jeff Gundlach consider could signal the end of the 35-year bull market in bonds. In other words, we could see yields pick up once again, perhaps topping 3% this time on the 10-year, which will bring further problems for the US stock market. So it may be a tad soon to look to “buy the dip” unless you have the stomach to handle another lurch lower.

Tailwinds for equities

But while it’s not always a good idea to run with the consensus, overall there do seem to be more tailwinds for equities than headwinds. Earnings are strong; Trump is tearing up troublesome business regulations; tax reform is helpful; infrastructure spending is on its way and no one seems bothered by increased budget deficits. That means certain stocks could soon start to look attractive again from a pricing point of view. But then the big question will be whether the major US indices can take out the old highs or not? If they recover quickly, then markets will quickly become stretched in valuation terms again. If they can’t take out the old highs, then we may have established a top over the medium term. This would make sense seeing that the Fed is withdrawing monetary stimulus with other central banks expected to follow. If so, then maybe we’re finally returning to the type of markets we had before the financial crisis – ones that rise and fall independent of central bank activity.



Any information, analysis, opinion, commentary or research-based material on this page is for information purposes only and is not, in any circumstances, intended to be an offer of, or solicitation for, a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. Any person acting on it does so entirely at their own risk and GKFX accepts no responsibility for any adverse trading decisions. You should seek independent advice if you do not understand the associated risks.