Friday, July 28, 2017

The Silence of the VIX?

Earlier this week, Saqib Iqbal Ahmed of Reuters reported, Volatility plunge sends VIX index to 23-year low:
Strong earnings boosted U.S. stocks on Tuesday, driving the S&P 500 to a record high while also sending a popular options-based gauge of expected price volatility down to a more than 23-year low.

The CBOE volatility index, better known as the VIX and the most widely followed barometer of expected near-term stock market volatility, fell to 9.04 intraday on Tuesday, its lowest since December, 1993, before rebounding to close at 9.43.

The VIX is derived from the price of S&P 500 index options. A low VIX reading typically indicates a bullish outlook for stocks.

The volatility index, whose long-term average level is around 20, has been extremely subdued this year as a surging stock market has chilled demand for options that provide protection against price declines, driving down the index itself.

The index has now closed below 10 for the ninth straight day, its longest such streak ever.

Market experts peg the relative tranquility to factors including a generally upbeat macroeconomic backdrop and the lack of any big events that could stoke volatility.

And the sense of calm is not restricted to the equity markets. Merrill Lynch’s gauge of one-month U.S. Treasury market volatility was at 46.9963, a record low.

To be sure, some traders in the options market have taken advantage of subdued levels of volatility to load up on contracts that profit from a pick-up in stock gyrations.

“Over the past few days, we’ve seen a tremendous amount of options activity in VIX,” Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors in New York, said in a research note. “These trades all have a common theme – investors expect volatility to move higher after the summer.”

On Friday, more than a million VIX options contracts traded in one go. The trader makes money as long as the VIX is between 12 and 35 at the October expiry.


There's been a lot of talk about the mystery trader who made a massive bet that the stock market will go crazy by October. Is it Soros, Druckenmiller, or Dalio?

I have no idea but this mystery trader isn't the only one thinking along these lines. Jennifer Ablan of Reuters reports, Gundlach's DoubleLine purchased five-month put options on S&P 500:
Jeffrey Gundlach's DoubleLine Capital purchased some five-month put options on the Standard & Poor's 500 Index a couple days ago as the CBOE Volatility Index .VIX fell to its lowest since December 1993.

"We lost money the first day we put on the trade, but now we are doing great. This is like free money," Gundlach, who is known on Wall Street as the Bond King, said in a telephone interview on Thursday. "We are in a seasonally weak period for stocks, but more importantly, we think the VIX was really, really low. So the S&P puts are going long volatility."

The CBOE Volatility Index, better known as the VIX and the most widely followed barometer of expected near-term stock market volatility, on Thursday spiked above 11 for the first time since July 11 while its true range, a measure of internal swings, shot to its highest since June 29.

"Now we wished we had done more," said Gundlach, the chief executive officer at DoubleLine, which oversees $110 billion in assets under management. The put options on the S&P 500 translate into "going long volatility. The price is ridiculously low" on VIX, Gundlach said.

Gundlach said he still has exposure to gold and predicted gold prices would rise because "gold looks cheap compared to markets that have rallied a lot, including bitcoin and including Amazon (AMZN.O)."

Late Thursday, Amazon shares came under selling pressure, dropping more than 4 percent before paring losses, as the company reported a 77 percent slump in quarterly profit.
So, is Gundlach right? Is the price of the VIX "ridiculously low"? Well, only time will tell because if this market continues to rally going into year-end, the price of volatility will remain subdued longer than Gundlach and that mystery trader can remain solvent (tongue in cheek play on the old expression "markets can stay irrational longer than you can stay solvent").

Have a look at the daily chart of the iPath. S&P 500 VIX Short-Term Futures ETN (VXX):


Notice how it has been declining over the last year and when it spikes, it's unable to stay above its 50-day moving average?

Now, let's look at a longer-term weekly chart going back five years (click on image):


Notice the pronounced decline over the last year and its inability to get and stay over its 10-week moving average?

Yeah, so what? All this technical analysis mumbo jumbo, what does it mean in practice? What it means is that while Gundlack and others might be right to go long volatility in the short run, it's far from certain they will make money if markets don't explode this fall.

The reality is those funds that have been shorting volatility have thus far been making off like bandits. Sure, they can go broke if volatility spikes and stays high, but so far, they've been right.

Still, some pretty smart money managers like Baupost's Seth Klarman have been warning investors to beware of those shorting volatility. Klarman has been raising cash to pounce on opportunities that will arise if markets get clobbered, and he's not alone.

Howard Marks, another one of the most respected value investors out there, warned his clients to move into lower-risk investments to protect against future losses:
"Given my view of the environment, the only reason to be aggressive today is because defensive investing implies low prospective returns. But the question is whether pursuing high expected returns through aggressiveness can be counted on to be rewarded," Marks wrote in the investor letter Wednesday. "If the answer is no, as I believe, then this is a time for caution."
This is sound advice but earlier this week, I had an exchange with Ross Kasarda, Director of Risk Management at the Virginia Retirement System which I will share with you below. He was responding to Seth Klarman's letter (click on image):


In short, there are legitimate concerns out there because all asset classes are overvalued, but there is so much liquidity out there that another risk is risk assets continue melting up quietly and everyone starts chasing returns higher and higher or risk underperforming their benchmark.

[Note: I say "risk assets" because I don't want to just focus on stocks. There are growing concerns that credit markets are in a heap of trouble as “covenant-lite” loans – risky instruments issued by junk-rated borrowers, with few protections for creditors – set an all-time record at the end of the second quarter.]

And if risk assets continue melting up, volatility will remain subdued for a lot longer. This is a problem because low volatility is already wreaking havoc on global macro gods and the calmness is also killing investment banks in Europe and elsewhere.

The irony is that the implosion of market volatility coincides with the big, fat ETF beta bubble I've been warning of. The $3 $4 trillion dollar shift in investing is giving many unsuspecting retail clients a false sense of security

Back in June, I asked whether ETFs are driving markets higher. You bet they are along with central banks expanding their balance sheets and corporations buying back shares at a record pace.

But the rise of ETFs has also spelled the death knell for market volatility. I discussed the technical factors as to why in my comment on hedge fund quants taking over the world:
One final note on ETFs and the VIX (or fear) index. As mentioned in this article, the rise of ETFs is impacting the volatility index through hedging activities:

Deshpande and other derivatives market experts say speculators are to a large extent just selling VIX futures to the issuers of exchange-traded products (ETPs) who need protection against volatility.

With the S&P 500 stock index near a record high, demand for these is quite strong.

For instance, money flows into the iPath S&P 500 VIX Short-Term Futures ETN (VXX), the most heavily traded long volatility ETP, are the strongest in three years, according to data from Lipper. In turn, that's creating a steady demand for VIX futures that the hedge funds are only too happy to supply.

"Strong inflows into long VIX ETPs means the issuers of these products have to go and buy VIX futures," Rocky Fishman, equity derivatives strategist at Deutsche Bank.

Even in the absence of those inflows, the way these ETP products work means that as market volatility declines it requires these product issuers to buy more VIX futures contracts.

It is in response to this strong demand for VIX futures that speculators have ramped up the selling of VIX futures. Essentially, these funds are acting as liquidity providers, not making outright bets.
In fact, back in April, Alex Rosenberg of CNBC reported, The rise of ETFs may be a cause of record-low volatility:
If the capital markets had to be characterized by one quality this year, it would be the low level of volatility. And if changes in investor behavior had to be characterized by one quality, it would be the rise of passive investing.

So are the two trends related?

Some experts, such as Sandler O'Neill research analyst Richard Repetto, see a connection.

"There's no one resounding answer to [why we've seen] this low volatility," Repetto, who covers the brokers and exchanges, said Tuesday on CNBC"s "Trading Nation." But the growth of assets in exchange-traded funds, which largely track indexes, "has had some impact."

Repetto pointed out that the first quarter of 2017 was the least volatile quarter for the S&P 500 in decades — which is just one among a host of stats showing how anomalous the lack of market movement has been.

Interestingly, this general decline in volatility has come in an environment in which it is not uncommon to see big volatility spikes in reaction to surprising events such as the U.K. vote to exit the European Union or Donald Trump's election.

The fact that the low level of realized volatility (which is distinct from, but largely explains, the low level of expected future volatility portrayed by the VIX) comes amid potentially anxiety-making world events leaves Repetto reaching for market structure-based causes.

"My explanation is that [high-frequency trading] and the growth of ETF assets are reducing volatility," Repetto wrote in a recent research note.

There may be something to this, acknowledged Seddik Meziani, professor of finance at Montclair State University's Feliciano School of Business.

"To a large extent, I disagree that low volatility is being caused by ETFs," Meziani, the author of three books about exchange-traded funds, told CNBC in a Thursday phone interview.

That said, "I would go so far as to say that it's exacerbated by this new tool. I would grant that maybe volatility wouldn't reach these highs and lows as easily if ETFs weren't around" given that "now you can express your sentiment toward the economy a little more easily."

Meziani's last point hints at a famous puzzle in finance. Why, academics such as Robert Shiller, have asked, are markets so much more volatile than the underlying economy?

"It has often been objected in popular discussions that stock price index are too 'volatile', i.e., that the movements in stock price indexes could not realistically be attributed to any objective new information, since movements in the indexes are 'too big' relative to actual subsequent movements in dividends," is how Shiller summed up the problem in a widely cited 1980 paper. And this was before stocks crashed in October 1987 for no apparent reason whatsoever.

When considered within this framework, it seems that fretting over the decline in volatility may be a bit silly — akin to demanding that a chef explain why a once-inedible dish no longer scorches the taste buds.

"If there is excess volatility due to non-fundamental reasons, eliminating it will result in lower volatility and more efficient markets," Stefano Giglio, associate professor of finance at the University of Chicago's Booth School at Business, wrote to CNBC on Monday.

"If market participants and arbitrageurs are able to eliminate some of the excess price fluctuations that are generated by deviations from fundamental values, this is certainly better for investors," Giglio added.

To be sure, it's far from obvious that a decline in volatility is good for investors.

As Ian Dew-Becker, assistant professor of finance at Northwestern's Kellogg school, pointed out in an email, it's hard to prove that equity volatility has indeed been higher than economic volatility.

On top of that, the recent decline in stock market volatility has come amid an "extremely stable" period for economic growth, which means that whether fundamental and actual volatility "have gotten closer to each other is a separate question that I don't know the answer to."

Finally, while reduced volatility lowers the risk of buying at a poor price, it also reduces the opportunity to buy at a great one.

Still, for the average investor who is more interested in seeing their money grow alongside the economy than in snatching up incredible bargains, the decline of volatility is probably a boon.

And the fact that one of the causes of this lower volatility may be their vehicle for doing so cheaply may be the icing on the cake.
I believe the rise of ETFs is contributing to record low volatility, along with central banks and other factors. This will mean that active managers who have been shunned over the last few years will come back in vogue (read Hegel to understand why).

While I am on the topic of market volatility, yesterday I swun by the offices of OpenMind Capital here in Montreal to visit its two principals, Karl Gauvin and Paul Turcotte (click on image):


You can read about them here. They are both extremely bright and they know their vol regimes extremely well. In fact, they even have a picture of vol regimes in their office (click on image):


I even met Karl's son, Simon, who was busy programming things while listening to music on his headphone (very nice young man).

Anyway, you don't know much about OpenMind Capital but I know enough to tell you that you should meet with them. They are not a hedge fund and don't charge hedge fund fees. They are smart alpha managers who have worked on great low vol strategies which you can read about here

Paul Turcotte previously worked at the Caisse, has a Ph.D. in physics from University of Montreal and is probably one of the nicest guys you will meet in finance (probably because he didn't study finance). When I tell you he knows his stuff, I am understating it.

Both Karl and Paul really know their stuff and I would ask investors reading this comment to contact Karl at kgauvin@openmindcapital.com so he can send you a recent presentation he made on retirement decumaltion strategies (click on image):


So, if they're so smart, why aren't they managing multi-millions yet? My answer to this is these guys are super smart, they're not marketing types at all and they are brutally honest with investors to the point where some might get scared away needlessly. The other problem is they have had issues labelling their strategies to satisfy certain potential investors (I told them yesterday to scrap L/S and stick to the  low vol label). Anyway, if you meet them, you will appreciate what I'm writing above.

Lastly, last Friday I sent my distribution list my top three macro conviction trades going into year-end and posted them on LinkedIn. They are listed below:
  1. Long US long bonds (TLT) is my highest conviction trade going into year-end, stay long & strong, US economy is slowing, bad economic data on the horizon.
  2. My other macro conviction trade is that the USD (UUP) will bottom soon and rally going into year-end. Start nibbling.
  3. My third and last macro conviction trade is to underweight/ short oil (USO), energy (XLE) and metals and mining (XME) as the global economy slows. Sell commodity indexes and currencies too.
I've embedded all three charts below and yes, all three trades are related and predicated on my view that the US economy is slowing and the global economy will follow suit (click on image):




Note, these charts are from last week and since then US longs bonds and the USD have dropped and oil and energy shares have rallied so you have plenty of time to jump on my macro trades and make great risk-adjusted returns going into year-end. Gundlach loves S&P puts and gold but I prefer US Treasurys (I believe they are a steal at these levels and will prove to be the ultimate diversifier).

I'm convinced the USD downtrend is being exacerbated by CTAs but when it reverses, it will be violent. This will send energy and commodity prices lower and no, I don't believe the fundamentals justify the euro or Canadian dollar (aka, the loonie) at these levels (if you do, you're smoking some good Canadian legalized pot).

Anyway, hope you enjoyed this comment, I'm taking a little break and will be back on Wednesday. Pay attention to US economic data next week, I believe it will be weak, offering support to my macro trades.

Please remember that I put a lot of time and effort writing this blog to provide you with great insights on markets and pensions so I do appreciate those that take the time to subcribe and donate via PayPal on the right-hand side. If you have never subscribed or donated, please take the time to do so.

Below, Richard Repetto of Sandler O’Neill discusses the causes of low volatility with Brian Sullivan (April 2017). A very interesting discussion on the causes of low vol.

And JPMorgan quant, Marko Kolanovic, may have dropped the whole market with report comparing today's risks to 1987. Take the time to listen to Kolanovic, I don't agree with all his recommendations (I'm short financials and energy) but he really knows his stuff and it does feel a bit like 87.

Third, Alberto Gallo, head of global macro strategies at Algebris U.K., discusses how the Federal Reserve plays into U.S. dollar strength and the effect that has on markets. He speaks with Bloomberg's Mark Barton on "Bloomberg Surveillance." Great discussion, listen to his views on using the US dollar as the new fear gauge.

Lastly, how come they don't make movies like this anymore? When it's all said and done, a lot of traders and funds shorting volatility will be wiped, screaming like the lambs that haunted Clarice.




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