What Happened To The Volatility?
The S&P 500 Volatility index, known in the mainstream media by it’s nickname “The Fear Index”, has fallen close to year to date lows at 11.98 as of Friday’s close. It has been a one way trip lower since the Brexit aftermath as the Bank of England and other central banks rushed to calm market swings in the wake of the United Kingdom’s vote to leave the European Union. Realized volatility has plunged since the second week of July as the S&P 500 has not made a move greater than 1% in 41 days now. The question of debate across financial media is, what the heck happened to the volatility?
If we check futures contract positioning there are two developments of note. Speculative positioning on the VIX recently hit a record level of short bets. Secondly, longs in S&P futures contracts have hit year to date highs. The Wall Street Journal published two interesting articles last month stating that pension funds in Hawaii and South Carolina have both moved around 10% of their assets under management into cash secured put writing strategies on the S&P 500 Index. These are relatively recent developments, but given the risk profile of your average pension fund this strategy seems like an spectacularly bad idea.
Pension funds and other real money investors turning towards the relatively risky game of selling puts on stock indices as a chase for yield would seem analogous to property and casualty insurers(AIG) selling credit default swaps on mortgage bonds during the housing bubble years. Keep in mind that if a pension fund in the quote pictured above is seeking $19 million a month in income on a $1.6bn notional amount, thats an over 15% annualized yield. Pension funds are taking on a massively risky, leveraged options strategy to get very high relative yields. Selling volatility on billions of dollars in notional cash amounts is very likely keeping a substantial bid under the market in these times of ultra low volumes. These put sellers are now pushing the volatility prices down to absurdly low levels relative to substantial economic and political risks in the next two months.
Economic data for the month of August showed deterioration in surveys released last week as the US ISM Manufacturing sentiment survey fell into contraction territory and job creation missed estimates. Chicago PMI and Empire manufacturing PMIs have also missed estimates, confirming the slow pace of economic growth seen in the first half of the year. A broader slowdown was made apparent yesterday as ISM Non Manufacturing missed projections at 51.4 versus an expectation of 55.4. The Citi Economic Surprise index is at 3 months lows, and the “bad news is good news” trend cannot continue for much longer. This market phenomenon is based on the data being not to good but not to bad, but we are now starting to lean towards data that is badly missing estimates.
On the political side, Donald Trump is rallying in the polls as the race is starting to take an eerily similar tone to the Brexit saga. Trump has closed a huge gap over the last two weeks and had a very strong showing in the last week with high profile visits to Mexico and Detroit. Trump is now leading in the CNN, LA Times and Rasumussen polls after being down nearly double digits in mid August. The battleground states of Pennsylvania and Florida have become absolutely imperative as we get down to the last two months. Florida shows Clinton up 3 points, and she is up 6 points in Pennsylvania. If polls in the key battleground states start to narrow we can expect markets to actually consider that Trump has a shot at winning. At some point the market will wake up to these risks and trade out of this remarkably tight range over the last two months.