The U.S. equity market continues to defy critics and rally on, closing last week above 1400 for the first time since May. Along with high stock prices, the VIX VXX index closed Friday within striking distance of its lowest levels over the past 5 years. Asset prices and especially volatility prices are telling us that there is little to no fear in the market presently, which means that contrarian timing appears highly favorable to the placement of bearish trades.
Shown below is a chart of the VIX over the past 5 years.
Surprisingly, the VIX is down over 3.5% as of Monday despite markets trading down significantly. If the VIX were to close at its current level of 13.98, this would be the lowest close on the VIX since June 2007. The fact that the VIX is at the lowest point since the peak of debt-fueled excesses of the market peak in 2007 is evidence that investors are shockingly complacent towards risk.
The VIX is also not alone in pricing extremely low volatility. From the euro to gold to crude oil, volatility is at or near multi-year lows. With the coming macro events foreseen in September but none remaining in August, investors appear to be willing to sell volatility currently with the idea that time decay will make them money over the next 3 weeks, at which point they can buy back their options.
In our estimation, this massive groupthink will be proven incorrect. While there are no obvious upcoming macro events, that does not mean risks have dissipated. Eurozone periphery sovereign yields are already creeping back up. Shown below are charts of the Spanish 3 year and 10 year yields.
While the initial euphoria from the ECB's proclamations 2 weeks ago caused bond yields to contract significantly, it appears that the good news effect has worn off. In fact, on the 10 year yield chart, the positive effect appears nothing more than a transitory correction rather than any meaningful change in trend. Even the 3 year yield, which is among the bonds the ECB claimed they would specifically support, appears to be creeping back up, with Spanish 3 year yields comfortably exceeding 5% again on Monday.
The problem for Europe is the same as it ever was: they are treating the symptoms of their problem rather than the problem itself. In a high growth, highly competitive economy, an almost unlimited amount of debt can be serviced. This is why countries like China can embark on trillion dollar stimulii at the drop of a hat. However, when the growth stops, especially in a highly uncompetitive environment like Europe, the ability of sovereigns to pay huge debt loads comes into question quickly. Bringing the problem to a head is the fact that Europe has traditionally been one of the "hard money" advocate central banks in the world, eschewing money-printing and inflation like the plague.
European leaders firmly believe that bond yields are the problem, but the real problem is that the European continent is mired in recession with no way out. The austerity measures that have been favored and are continuing to be implemented across Europe are sinking Europe deeper and deeper into recession, and there has been no discussion of relaxing such measures. Until such time as Europe has a demonstrable plan of returning to growth and competitiveness, any half-hearted plan to cap bond yields will fail as quickly as it is announced. Ironically, the devaluation of the euro and financial assets in Europe caused by the mismanagement of the crisis will eventually get Europe to a more pro-growth equilibrium, but it will also cause a catastrophic diminution in living standards. Such a drastic adjustment in living standards will have highly negative effects on emerging markets that have grown to depend on European exports, namely China, and eventually spreading to larger economies such as the U.S. as it already has to the UK. We believe the negative effects of this global slowdown epicentered in Europe will eventually cause lower stock prices and a great deal of volatility.
From the VIX chart above, while the VIX is clearly a mean-reverting index, punctuated by huge spikes and then long grinds lower, the 15 or below level is not a level at which the VIX tends to stay. Given that the VIX has stayed below 28 the entirety of 2012, a true spike in volatility is bound to be a significant event. As markets give off the appearance of relative calm and lack of movement, option market makers such as banks and high-frequency trading firms continue to happily sell options into the market, profiting as markets go nowhere over long stretches of time. However, if and when prices begin to move quickly to the downside, these market makers will need to sell stock short to hedge their short options exposure. This will accelerate the collapse to the downside enormously. Essentially, the longer the period of calm, the harder and sharper the decline will be.
Adding to the problem is the now extreme lack of volume in the market. Since the beginning of the year, volume on equity markets has been low, but recently volume has been extremely low. The chart below shows the S&P 500 index with volume in the lower pane.
As can be seen, average volume this year was significantly lower than 2011, but recently volume has absolutely dropped off a cliff. Average daily volume is now down to 578 million shares a day on the S&P 500 SPY, and volume Monday low 380 million shares, a level not seen since July 3rd, 2012 and December 29, 2011 which were holiday-related. Trading has been very light to say the least, and the fact that the market has continued marginally higher on extremely low volume is not a great sign.
Beyond the non-confirmatory nature of a low volume rally (which is actually a dubious reason to doubt the rally), the longer-term falloff in volume presents another huge pitfall if and when volatility does pick up. As stated above, market makers will look to short large swaths of stock as the market declines in order to hedge, but given how low volume is, it indicates that there is not much liquidity in markets presently. Because there appears to be far fewer participants in the equity market than there were just a year ago, there will be far fewer buyers if and when prices move south rapidly. This will only serve to exacerbate the decline even more.
The dangerous combination of obviously declining macro fundamentals, extremely low option prices, and general apathy in the markets make for an extremely potent cocktail. Such conditions always exist before market-jarring events, such as Black Monday in 1987, as well as the decline in 2008, 2010 and 2011. The nature of markets is that decline and collapse takes only days where gains take months or even years. In 1987, the stock market declined 35% in just 18 days, and in 2008 the S&P 500 fell 33% in just 20 days. Even in years when the bull market continued such as 2010 and 2011, the bulk of the decline happened in a very short period of time, highlighted by last year's 18% drop in just 3 weeks.
We believe this decline will prove no different, although the timing of the seminal moment is unclear. However, even over the coming weeks, there are plenty of landmines that markets will have to avoid. Among them are the German constitutional decision on the ESM, the troika's decision on whether to continue funding Greece, the next ECB and FOMC meeting and any other number of potential political pitfalls. What will be important to watch for is a decline in the indices that is followed by a rise that does not get back to making a new marginal high. Once the indices fail at that level, a very large decline could result quickly accompanied by a huge spike in the VIX. Depending on the circumstances surrounding that decline, the bulk of the loss of value will likely be already experienced by the time most people realize it is happening. At that time, it will actually be a good contrarian trade to be long.
The June 2013 1000 put on the SPX is now selling for $18.90 (the corresponding option on the SPY ETF would be the SPY June 2013 100 put), which we perceive to be an incredible value given how long-dated this option is. It is selling for under 30% implied volatility, which is also incredibly low given how high the risk to the system is and how far out of the money the strike price is. Investors should be scaling into this position over the coming weeks, especially if the VIX drops even further.
More adventurous traders could also look to purchase futures on the VIX directly. With many macro events set to take place in the first 2 weeks of September, the VIX futures contract expiring on September 18th is intriguing. The September VIX is trading at 18.10. Even if the VIX were to settle at Monday's settlement of 13.70 on September 18th, a case we perceive to be extremely unlikely given how low the VIX is on a historical basis, this would produce a loss of $4,400. We would consider this to be the maximum possible loss on the trade, but the maximum gain on the trade would be much greater. Even a return to the 50 day moving average for 2nd month VIX futures would result in a gain of $4,000, with a return to the early June peak of this year's VIX resulting in an $11k+ gain. We view the risk/reward on this trade to be highly attractive given the growing disconnect between option prices and global macroeconomic risks.
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Disclosure: I am long S&P 500 put options and VIX futures.
Disclaimer: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.