Back in June, Deutsche Bank’s Aleksandar Kocic set out to quantify complacency.
While there’s certainly been no shortage of commentary containing the term “complacency” from analysts and pundits, the idea of putting a number on it was new.
Kocic’s approach was relatively straightforward and his note (which you can read in the linked post above) explaining the rationale and method was characteristically brilliant. Here’s an excerpt:
We approach the problem of quantifying complacency … by comparing the two different measures of economic uncertainties: Economic policy uncertainty index and VIX (implied S&P volatility).
Until 2012, for the most part (but not always) both levels and spikes tend to be coordinated across two measures. When VIX is in tune with EPU, the market is acknowledging the levels of risk through the prices. When VIX is low and EPU high, markets are complacent – they are underpricing risk. Spikes across different events are summarized in the Table (chronologically, from left to right). After 2011, the two measures of risk decouple with VIX consistently low despite growing uncertainty. The breakdown is structural, and it is visible across all market sectors, not only equities.
In order to quantify market complacency, we compare the two measures in the following way. We regress EPU onto VIX until 2011 und treat the residuals as the measure of complacency. The two Figures show the EPU index overlaid with the regression scaled VIX and the residuals.
Ok, so that was in late June.
Fast forward a couple of months and although the VIX has seen episodic spikes tied directly to the things that come out of Donald Trump’s mouth, things are still relatively calm and this morning’s risk-off mood notwithstanding, Tuesday’s price action seems to suggest that the BTFD, “mean reversion” regime remains deeply entrenched.
That said, you might be tempted to think that the residual on the EPU onto VIX regression would be rising given the fraught geopolitical and policy backdrop.
As it turns out, you’d be wrong – or at least on the latest available reading.
And you’d be wrong for precisely the reason that Kocic began to explain on Tuesday: namely that while tail risk may be growing, all we’ve really seen this month is more evidence that dissensus is the order of the day and dissensus is one of two paradigms that lead to suppressed vol. (“Volatility declines either when the markets are predictable or when there is no consensus”).
With all of that as the context, consider the following from a client note by Kocic that’s circulating on Wednesday…
While political tensions have been growing, the market appears to be largely indifferent to them. One would tempt to rush to a conclusion that the markets have lost any sense of risk aversion and that complacency has reached new highs. However, when examined at higher resolution, they lead to a different conclusion: Complacency has declined sharply this summer.
(As we have argued in the past) market complacency can be extracted from the comparison between the Economic Policy Index and market volatility. The chart shows the EPU vs. (scaled) VIX (last point: Jul-31). Their spread (which is a measure of complacency) continues to collapse from its peak in January.
The resolution behind this seemingly counterintuitive result lies in the way the policy uncertainty is determined. Economic Policy Uncertainty index is constructed by counting the frequency of articles in ten leading US newspapers that contain three of the target terms: economy, uncertainty; and one or more of Congress, deficit, Federal Reserve, legislation, regulation or White House. These numbers are properly normalized by their means and standard deviations of occurrence and combined into an aggregate index.
Yes, the recent rhetoric has been politically and emotionally charged, but it did not contain much of what is traditionally considered as the market-sensitive information. Consequently, the word count that comprises the EPU and calibrates the level of market-sensitive information in the public discourse and media, dropped down dramatically, while the markets remained calm and volatilities did not spike.
It is unlikely that even the last night comments would change that as they concern more of the tail risk, rather than general shift in uncertainty.