A Mean Reversion (For Volatility) Might Lead To A Big Migration (For Equities)

About: iPath S&P 500 VIX Short-Term Futures ETN (VXX), Includes: AGG, HYG, JNK, LQD, SPY, TVIX, UVXY, XIV
by: The Fortune Teller

While equities trade at record highs, volatility trades at record lows.

A mean reversion for volatility might lead to a big migration for equities.

Here's why I'm long UVXY from sub-30 with a target price of 45-50.

According to a most recent CNN Poll that was conducted by SSRS, 62% of Americans think that the North Korea regime is a "deep threat" to the US. That's a much higher result than the 48% who said the same five months ago. As a matter of fact, this is the highest level that figure has reached in 18 years.

President Donald Trump is fully aware of this as evident by his Twitter account. With that in mind, it's no wonder that the VIX (VXX, XIV, TVIX, UVXY) - aka "the fear index" - has jumped 20% over the last few days and over 40% since its record low just two weeks ago.

Is it time to buy volatility? Is it time to move to a long VIX position?

First of all, it's important to understand what is the VIX. Here's an extract from the CBOE (which operates the gauge) website featuring the VIX fact-sheet:

As you can clearly see from the above data, the VIX can (and possibly should) reach much higher levels (than where it trades these days) at times of heightened levels of fear and uncertainty.

Secondly, it's important to understand where we are both statistically and historically.

Here is some data regarding the VIX over the past five years:

Average on a monthly basis: 14.98

Average on a daily basis: 14.83

Highest (August 24th, 2015): 53.29

Lowest (July 26th, 2017): 8.84

Even if you look at the VIX over the past year (see below) it's easy to see how distressed are the levels/averages that the VIX has been trading at recently.

If we were at a time where things are calm and everything move along smoothly - one could argue that the VIX trades where it belongs. Nonetheless, you don't even need to look at North Korea to figure out that things are far from being calm and/or smooth. Almost everything - from fiscal policy (no reforms/bills as of yet) to the debt ceiling (upcoming debate), from the Fed's actual interest rates hiking to its intended balance sheet unwinding, from the inter White House relationships to the current administration relationships with its main foreign allies - points at anything but calm and smooth.

Now let's take a closer look at investors/speculators VIX positioning. Here's the most recent, last Friday's CFTC data pointing at record high VIX net short positions:

Putting it differently, short VIX is a very crowded trade and most investors put themselves on the same (short) side of the (volatility) boat. This means that the "volatility boat" may become very volatile itself and those investors/speculators who short the VIX might be subject to an extreme short squeeze event if things go the other way, i.e. the VIX climbs. If you think that the VIX needs to climb much for this to happen - you're wrong. Not only that it doesn't require much for this to happen but the VIX moving to its five-year average would be sufficient to create this panic.

The main question is, therefore, what does this recent spike in volatility suggests and should investors turn less bullish and more cautious?

Mean reversion is a theory suggesting that prices/returns eventually move back toward their (usually long term) average/mean. Between 1990 and mid 2012, the VIX average level was ~20. Since mid-2012 to date (five-year time), the VIX average level was ~15. What we see recently should, therefore, be seen as a normal move of volatility towards its long-term average.

Some may claim that 2017 is a "new era" for the VIX and that since the current levels are already higher than the 200/50-days moving average - the VIX doesn't have much more room to climb:

Maybe yes, maybe no.

What I do know for sure is that over the next two months we have three mega events (that we are currently aware of) that may take the VIX to higher, much higher, levels:

  • North Korea potential war
  • Fed's balance sheet unwinding
  • Debt ceiling debate/decision

This doesn't take into consideration "minor noises" that can come from all sorts of random/unexpected sources/events - e.g. tweets, Russian probe/collusion, trade war, sanctions, terror, etc. - not to mention black swans (when was the last time we had one?).

Point is, VIX is low. Historically, statistically and fundamentally.

What is holding the VIX so low? The answer is very simple: Risky assets valuations. Prices of equities (DIA, QQQ, SPY) and credits (LQD, AGG, HYG, JNK) make everything look peaceful and calm although nothing really is - quite the contrary.

It's beyond my grasp how money keeps pouring into the financial markets without any sense of hesitation or fear. People buy basically everything without distinguishing between/caring about cheap vs. expensive, attractive vs. risky, right vs. wrong. This is not a market but a casino or, more accurately, a Ponzi scheme that everybody seems so anxious to be part of.

Remember the musical chairs game that we used to play in kindergarten? The peaceful and clam game that see kids circling around few chairs while the number of chairs is smaller than the number of kids? At some point the music stops and one kid (at a time) is leaving the game. Nonetheless, even if the music is still on but the end-of-day bell is ringing - all the kids run to the door (even if the game hasn't come to an end yet). This is exactly what may happen to the markets soon enough (let's agree on a 12-month period, shall we?). At the moment, we may only read/see "one kid" leaving the "game" every now and then. Nonetheless, when the "bell" rings the next time - we may see all the kids rushing to the door at once.

The main, however, between the game and real life is that in the stock market you won't be able to hear a bell rings. There will be no bell ringing before the run to safety, perhaps only after...

Quoting what Jeffrey Gundlach, CEO of DoubleLine, said yesterday on CNBC:

The VIX has been trending lower for months, with brief and short-lived up-thrusts. In the daily chart, below, we can see the down trend and negative slope for the 200-day moving average line. Notice the higher lows from the 12-day momentum study? The lows from May to June to July have been higher and higher even as the VIX has gone lower and lower. This difference is called a bullish divergence by technical analysts. The pace of the decline since May has slowed. In the lower panel the trend-following Moving Average Convergence Divergence (MACD) oscillator also has made higher lows and is crossing above the zero line for an outright go-long signal. When you give someone the timing and the direction of a trade they still want more. People also want to know where or a price target. In this Point and Figure chart of the Volatility Index on the CBOE, below, we can see that 117.60 is key breakout point and a potential target of 179.20 is projected.

I'm looking for VIX to spike to 15-16, at the very minimum. If and when we reach this level - I'll reassess. A move from 12 to 15-16 equals 25%-33%. The UVXY supposed to deliver twice as much, i.e. 50%-66%. That mean that from a UVXY at $30 (when the VIX at ~12) one may expect the UVXY to reach $45-50 (when the VIX ~15-16).

After years of falling VIX we may be witnessing a mean reversion. A mean reversion move for the VIX might be combined with a big migration for the SPY, where everybody run in the opposite direction at the same time:

Beware of the wild! Wild times, not wildebeests, although investors do sometimes tend to behave like the latter; and when they do (rushing, altogether, to the gate at once) - you better not stand on their way.

Disclosure: I am/we are long UVXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.