Summary:
Thus far in 2014 theres only one notable capital markets trend: volatility is back. Maybe not in a Normal way just yet – the CBOE VIX Index closed at 14.8 today, still well off its long run average of 20. It is, however, meaningfully higher than the 12-13 rut which markets occupied from November 2013 to the beginning of the current year.
Our monthly review of the Implied Volatility (IV) measurements for a host of asset classes and industry groups confirms this finding. IVs – think of them as the VIX of everything from small cap stocks to gold/silver and various industrial sectors – are up 3-46 percent in the past month. At the upper end of that range are domestic mid cap stocks, large cap telecomm and industrials names, and non-U.S. developed economy markets. Nearer the lower bound are silver, gold and investment grade corporate bonds. The IV moves here arent performance based, as they tend to be over a longer term time frame. Rather, options markets are pricing in more risk across the board. Look for a spicy back half of Q1 2014; U.S. stocks should grind higher, but with more volatility than weve seen in quite some time.
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The Daytona 500 NASCAR race is this weekend, an event that always reminds me of quote often attributed to Ernest Hemingway: There are only three sports – bullfighting, motor racing, and mountaineering. All the rest are merely games.
Its not clear if Papa ever really said it, but his sensibility is certainly in evidence. Without the risk of death or serious injury there is no real meaning to a sporting endeavor; it is Just a game. And even with all the advances in safety, motorsports are still quite dangerous. At one point NASCAR even adopted a version of Hemingways observation as their tagline – Everything else is just a game.
The tradeoff between risk and return is also, of course, a cornerstone of modern finance. You cant have more of one without the other if you already own a well-diversified portfolio. Investor appetite for risk does vary over time, of course. Thats a core explanation of why capital markets suffer with endless cycles of booms and busts. The latest Pop was so loud and scared so many people that it took extremely aggressive moves from the Federal Reserve to calm the waters. The combination of five years of zero short term interest rates and +$3 trillion of asset purchases did finally do the trick, even if the current recovery isnt especially robust.
Even though we dont think U.S. stocks are (yet) in danger of reaching Bubble territory, it became clear last year that price volatility was simply too low. The bubble was in complacency, rather than valuation. The CBOE VIX Index, the most common measure of near term expectations for price volatility, stayed in a band of 12-13 for much of the fourth quarter. Thats more than one standard deviation (of 6) away from the 30 year average of 20. Actual volatility for the S&P 500 was 8-10 from mid-November to mid-January 2014 and that acted much like an anchor on the VIX as well.
Is Low-Volatility Gone?
The low-volatility bubble is now clearly bursting, and thats a good thing. Thirty day historical volatility for the S&P 500 (as measured by price action in the SPY ETF) is now over 14, up 75 percent from the late November lows. The VIX may not be back to that 20 long term average soon, but it is at least within one sigma at +14. Why the beginning of a much-awaited mean reversion?
We can think of three factors at least:
1. Rightly or wrongly, capital markets clearly viewed the Feds Quantitative Easing program as a bottomless ATM of cash to invest in stocks and other assets. The risks to being short on days when the Fed was injecting liquidity became a running joke on financial blogs, and rightly so. Now that the Federal Reserve is clearly and unambiguously taking steps to end QE, that prop is getting smaller. And in its place we get more price volatility.
2. Emerging markets are getting riskier, and investors know their tendrils spread throughout the global financial system. It is simply too early to tell how this plays out. One thing is clear: with global economic growth still slow, any macro disruption will take a greater toll than if there were more favorable tailwinds helping capital markets and asset prices. There is also a clear connection between this and the prior point, although the Fed has been clear that their priorities are with the domestic economy.
3. U.S. stock valuations are no longer as cheap as they were in 2013. We began last year with stocks trading for just less than 14 times earnings. Now they are closer to 16 times, and the expectation of higher interest rates likely puts a cap on further multiple expansion. Yes, we could get to 1900 on the S&P 500 this year. But it wont be a smooth ride, as it was in 2013.
The Market Is Baking
Another way we know the market is baking in the expectation of larger future price swings is to look at the Implied Volatilities (IV) imbedded in the options prices for a range of exchange traded funds which track a wide array of asset types and industry groups. Weve done this every month for several years, and the results of our most recent analysis appear in two charts at the end of this text. Here is our summary:
The IVs for every asset class and industry sector we track were up over the last 30 days. This is an unusual development and hasnt occurred for many months. These IVs are essentially the VIX of everything from gold to silver to stocks to corporate bonds, and every one of them is higher than this time in January.
At the low end of the increase in IVs are assets like gold, silver and investment grade corporate bonds, up between 3 and 14%. Yes, these are among the better performing assets over the past month, but historically IV and price performance are inversely related. In this case, good performance is not translating into greater confidence that these asset types will have an easy ride ahead. That is a notable anomaly.
At the other end of the risk spectrum, mid-cap U.S. stocks, large cap telecomm and industrial names, and developed non-US economy (Europe, Asia, Far East) stocks are bearing the brunt of the markets macro fears. Their IVs are up from 31-46%. Why the mid cap names? Perhaps because unlike the large cap S&P 500 or small cap 600, the mid cap 400 is actually up on the year. It may not be much of a gain, just 0.9%, but that may be enough to worry over its outperformance relative to its peer indices.
As the accompanying performance chart shows, the last month has been a mixed bag for the asset classes that we track. Eleven of the 19 on our list are up on the month, and 8 are down. But again, while the price action shows variety, the IV moves are all to the upside. For those of you with a mathematical inclination, you might wonder why upside price action might not increase the IVs imbedded in options prices. The short answer is that it can, over a day or two or three. But over a month, IV and price direction tend to be inversely correlated. One goes up when the other goes down.
The Slow Climb
For those of you with less interest the math, remember the old aphorism: markets take the stairs up but the escalator down. Options pricing tends to anchor around the speed of movement, so higher IVs tend to show market concern over price declines rather than advances.
Math aside, what do you do with these observations? The short answer is to prepare for more volatility than weve seen over much of the past year. And thats OK. As any race car driver will tell you, a little fear can be a good thing. It keeps you from taking outsized or stupid risks. And that can be what keeps you alive.
Nicholas Colas, chief market strategist at ConvergEx Group, a global brokerage company based in New York.
