On Tuesday, as the morning equity euphoria in the U.S. disappeared into an afternoon cloud of “WTF?” (with the Dow inexplicably erasing a 283 point gain), the VIX rose 22% at one point to a six-week high of 12.41.
To be sure, that’s still markedly lower than the post-crisis average.
Still, what we saw on Tuesday suggested to some folks that the tide may be finally be turning.
For instance, in a note dated yesterday, Pravit Chintawongvanich of Macro Risk Advisors opined that “volatility may have found a floor.” Recall the following chart from Bloomberg’s Luke Kawa which garnered more than a little attention on Tuesday:
The price for puts relative to calls is now two standard deviations below the five-year average. In his Tuesday note, the above-mentioned Chintawongvanich marvels at the “incredibly outsized returns” for calls. To wit:
[Look at] SPX Jan 2750 calls. They went from 60 cent offered on 12/29 to $40 mid on Friday. The incredibly outsized return for this SPX call option is a perfect illustration for how underpriced the “right tail risk” has been, and why volatility may have found a floor.
That, Chintawongvanich exclaims, proves that “the right tail must be respected too!”
And then there’s correlations. Last week, Goldman was out with a lengthy note explaining that the plunge in correlations in 2017 seemed to suggest that the rise of passive investing (which of course has continued largely unabated) is less important than macro. As macro risk subsided, correlations dropped, although because volatility was suppressed, the opportunities for stock pickers were constrained. Here’s Goldman:
We find that stock-picking opportunities are highest when equities are in the Growth phase of the equity cycle and when the economic cycle extends. This is because in this phase returns are driven by actual earnings growth rather than by expectations of a recovery or a deterioration in the cycle. In these parts of the business and equity cycle, pairwise correlations tend to be the lowest and the source of dispersion more micro-driven. When the economic backdrop improves and sentiment is ‘risk on’, company fundamentals tend to be at play, as the influence from macro drivers of sector performance fades.
Right. Unless of course everyone says “fuck it” and goes all-in which, apparently, is what’s currently happening.
“What’s also interesting is that correlation of S&P stocks to each other has actually been increasing as the market rallies [where] typically we see the reverse – when times are good and the market rallies, realized correlation typically decreases as individual sector and stock performance begins to matter more,” Chintawongvanich goes on to observe, before adding that “the increase in realized correlation over the past 2 months as the market rallies possibly points to broad buying of equities – a ‘melt up’ so to speak.”
Yes, a “melt-up” “so to speak.” And indeed lots of folks have been tossing that term (and its bombastic cousin “blow-off top”) around over the past couple of months including, most recently, Jeremy Grantham.
In any event, the most notable bit from Chintawongvanich’s piece is his rationale for claiming that the VIX may have found a floor. To wit:
The outsized performance of those teeny call options shows that volatility was, in fact, “too low.” In other words, somebody snuck one in past the goalkeeper. What that means is the options market will probably keep somewhat of a bid to vol, preventing those upside call options from getting THAT cheap again for some time.