Volatility Near Historical Lows: Good Time to Buy Portfolio Insurance?

Recent market action in the US has made me think of what was going on about one year ago.

A lot of market participants were prepared for what happened in May and June of last year. We weren’t the only ones with put options in play at that time.

The run up from October plus a string of key indicators seemed to make a clear case for protection. In hindsight, the graph below seems to make the drop in the first quarter of this year something even more foreseeable. Take a look at that (basically) straight line up from mid July to late February. If only life were that certain … well, an uneventful life isn’t great either. Whether it was the Chinese market’s sell off or any of a few dozen other reasons, that was a market that needed to let off some steam.

Here’s the 2-year chart of the S&P 500:

I have commented on VIX many times in the past. Here’s the 2-year chart of the S&P 500 with VIX overlaid:

And VIX in isolation, again for the past 2 years:

We’re not back to the historical lows of 10 but don’t let this graph fool you. 14 is not the historical average. Here’s the longer term chart from Yahoo Finance:

In this seventeen and a half year chart, 20 looks more like the longer term average. Note that when the markets fell (and fell hard) in late February, VIX spiked up to just under 20. It’s an understatement to say that we’re in a low vol environment.

Total speculation here but a pattern nonetheless: Note how VIX seems to have a longer term trend bringing it from the plus-20 range to the 10-15 range, like it did from 1990 to 1995. Likewise on the upside, VIX took a few years to go from the 10-15 range (1995) back up above the plus-20 range (1997-98). The downside trend from early 2003 to 2005 is another example. There’s no denying that there is significant “volatility of volatility” like we’ve seen from 1998-2002 and from early 2005 to now. These would seem to look like periods of a “sideways” trends on this longer term chart. The question now is if an upward movement of VIX would again happen in a 2-3 year period taking it from the 10-15 range back up to range in the plus-20s. My guess is it’s just a matter of time before VIX makes that climb up and I think it will be sooner rather than later. This is actually an area where I have been reading up on and if you search online, there are a surprising number of market participants and academics who discuss the longer-term views/forecasts of VIX.

Now, the second chart above shows that in the shorter term, spikes in VIX coincide with sharp drops in the broader US market. However, the longer term chart above does not have the same pattern. Here’s the same long-term chart with the S&P 500 overlaid:

Note that I had to switch from a log-based vertical axis to a linear based axis to make the chart more easy to read. The key here is that in the shorter term, VIX and the S&P 500 can (but will not always) move in opposite directions. They move in opposite directions in times of extreme market movement. However, in the longer term, for example during the bull market of the late 1990’s, we can see that VIX and the S&P 500 can move in tandem. It’s all about the implicit volatility as measured based on prices of S&P option contracts but I won’t go into the math of Black-Scholes.

The follow up question then is how do you feel about this chart? S&P 500 (and just about every indicator for just about every asset class) is near or at historical highs. VIX is close to historical lows. The rubber band is being pulled tighter and reversion to the mean is providing some significant pull.

Let me be blunt: The S&P 500 is now somewhere above 1500 where it hasn’t been since September 2000. I see it’s closed today just under 1510 so it’s roughly 18 points short of its record close of 1527.50 back in March 2000. So another 1% rise ought to do it. Being up roughly 6.5% year-to-date, another 1% seems easy.

In addition, I’ve seen A LOT of commentary on this online but I’ll add it here anyway: The S&P 500 has gone up in 23 of the past 26 trading days — the longest such streak since 1944. Well, if you add today, it’s now 24 of 27 days. A hockey team with 24 wins in the past 27 games would be considered “on fire”. A boxer with a 24-3 record would likely be the title holder. But this ain’t no sport. 24 ups in the past 27 days should bring a cautionary “spidey sense” to investors.

[UPDATE] According to this article from CNNMoney.com, the run of 24 ups in the past 27 days for the Dow 30 ties a record from 1927. I think this stat will be repeated SO many times in the next few days … and imagine if today is another up day!

Just a string of facts. A possible time for tactical measures? A boy scout would call it preparedness. I think that options should already be in play … if you’ve been invested in the S&P 500, then you have about a 6.3% return since the end of March. Some of that return could finance some put options for even a partial hedge.

So, next question (I think we’re up to number 3 now) is whether now is a good time, especially with volatility near historical lows, to buy some portfolio insurance?

The follow up to that is whether you want to go even further and set triggers for shorting futures or purchasing inverse ETFs. I’m still thinking tactically here. You have to do the same with your own philosophy of asset allocation. Are you more long-term oriented, thus focused on strategic asset allocation, or do you have a shorter-term perspective? If the latter, then you’re already thinking about tactical measures, if not implemented already.

Why not a few more charts? Everything below is charts for ProShares’ inverse ETFs showing performance since their respective inception date. Here’s the inverse and double-inverse for the QQQ:

Here’s the inverse and double-inverse for the Dow 30:

Here’s the inverse and double-inverse for the S&P 500:

Here’s the inverse and double-inverse for the S&P Mid Cap 400:

Here’s the inverse and double-inverse for the S&P Small Cap 600:

Here’s the inverse and double-inverse for the Russell 2000:

We can see from the first four charts that it’s been tough to go against the market. The small cap market, through either the S&P 600 or the Russell 2000 have only been available in an inverse ETF for a short time and there seems to have been little interest in them as shown by the trading volumes for the bottom two charts. My feeling is that all of these inverse ETFs, including the small cap exposures will begin to see increased trading volumes in the coming weeks. There is already a significant level of short interest according to communications from the sell side and we know that fund flows are coming out of equity funds and into bond funds. So, perhaps like about one year ago, investors are preparing for the storm.

This posting is not a recommendation for any of these inverse ETFs. For those of you looking to protect/hedge existing positions, only you know what you hold whether it be mega caps (you’re likely looking at DOG or DXD) or a tech heavy portfolio (consider PSQ/QID). Also note that ProShares also has short exposures to value and growth tilted indices as well eleven sectors. For these cases, all are for domestic indices and all have 200% short exposure. For those of you looking for something in the ETF space beyond these such as international exposures, you’ll have to consider shorting ETFs. I am absolute amazed at how long it’s taking other ETF participants (Rydex) to get into the inverse ETF space. I see a parallel here to the GLD/IAU situation in gold ETFs. If Rydex doesn’t get in here soon, they’ll “pull an IAU”.

Final note: If we’re basically talking about market timing here and all of the above seems pointless, you can simply take some profits and thereby build a cash position to buffer downside volatility!

Comments

[ikkyu]

Mr Kang,

Thanks for this. Addtionally, the put/call ratio is at a 6 month low. Short interest is rising but well below its all time peak of several weeks ago. I think everyone is gun-shy form previous short attempts!

I find that 20 period bollinger bands around VIX/VXN are very useful to show the relative vola of vola.

Cheers,
john