Vol, Liquidity And Flying Toasters (One Week To Go)

The data calendar is sparse in 2021’s final week. Odds are you’ll still get an automated “out of office” reply if you try to email anyone using their work address.

The irony in the pandemic era is that the term “home office” is no longer just a description of a superfluous room with a lonely desktop computer collecting dust and running flying toasters. Your home actually is your office now. For many, that’s likely to be the case in perpetuity.

Maybe automated replies should be more forthcoming — you’re not “out of office,” you’re just “ignoring emails.” The only way you’re really out of office is if you’re not home. And if you’re not home, where did you go? I hope you remembered your respirator, vaccine passport and Lysol spray (“Hand me down the shark repellent bat spray!“). Otherwise, you won’t be going to any restaurants. Or movie theaters. Or anywhere with four walls and a roof.

So, you may as well stay home, at the office, and answer emails. After all, there’s nothing more nauseating than staring at a neglected inbox on a Monday morning in mid-January and wondering where to start. Unless you count trying to kick a two-decade, two fifths per day scotch habit. That’s more nauseating. It’s also another story. For another time.

In any case, a thin data docket need not mean a lack of fireworks. Not when markets are similarly thin. Remember, volatility is inversely correlated to market depth. Things were never the same after February 2018 (figure below).

Crucially — and this is a frequent talking point — thin markets can just as easily contribute to outsized rallies as they can amplify declines. Recall that December of 2018 would have been materially worse were it not for a late stick save as rebalancing flows hit in a thin market.

“One should note that large short positions likely need to be closed before (the seasonally strong) January,” JPMorgan’s Marko Kolanovic said, while calling for a year-end rally on December 17, prior to new highs hit on the S&P just before Christmas. “Given that market liquidity is dwindling, the impact of closing shorts may be bigger than the impact of opening them, when liquidity conditions were better,” he added.

One assumes month- and quarter-end rebalancing flows will be in play, and after dramatic de-leveraging following a spike in realized volatility, CTAs and vol control could be a source of mechanical demand for equities over the next few weeks assuming, of course, stocks don’t continue to realize outsized daily changes.

Read more: The Potential For ‘Squeezy’ Year-End

Note that the recent Omicron- / hawkish Fed-inspired spike notwithstanding, realized vol returned to pre-COVID levels in 2021. “The overall level of SPX realized volatility and the distribution of individual-day returns have closely resembled 2019’s,” Goldman’s Rocky Fishman wrote, in a December 21 note.

The figure (below, from Goldman) gives you a sense of things from a 30,000-foot level.

However, this discussion always comes back to the “broken” vol complex, which is bedeviled by a supply/demand imbalance, among other factors. Fishman called realized vol in 2021 “a misleading hint of a return to normalcy.”

“VIX levels and other derivative market metrics have painted a different picture,” he said, in the course of reiterating the defining feature of today’s vol landscape. “Many skew metrics and volatility risk premium metrics have had higher median levels in 2021 than ever before.”

Again, the problem is a supply/demand disconnect. Dealers are constrained in their capacity to be short size in crash hedges and tail risk due to VaR risk management and onerous regulatory burdens. Additionally, fixed income investors may be looking to equities vol for hedges amid what many perceive to be a growing risk that the tried-and-true, decadesold, negative stock-bond correlation will no longer hold coming out of a forty-year bond bull, and into a reflationary regime characterized by massive stimulus, potentially combustible monetary-fiscal policy “partnerships” and pent-up demand that could be released into the (still partially dormant) economy if COVID ever gets “downgraded” to something akin to the seasonal flu.

Read more: How Broken Is The Vol Complex?

Commenting on the persistence of extremes in skew and vol premium, Fishman spoke of “pervasive risk aversion as investors assess the likelihood of a return to 2020-like volatility.” “Elevated demand for single stock options has likely boosted volatility risk premium in 2021 as well,” he added.

Switching gears, US equities enter 2022 riding on the shoulders of giants. “A third of the S&P 500’s gain this year has come from Microsoft, Apple, Google, Tesla and Facebook [and] if one adds in Nvidia and Amazon, the seven names generated nearly 40% of the benchmark’s increase,” JonesTrading’s Mike O’Rourke wrote, in his final note of 2021. The S&P’s market cap “now exceeds 175% of US GDP,” he said, a reading that represents a near 50% premium compared to the peak during the dot-com bubble.

Anyone who admits to being at work (i.e., at home) in the new week can look forward to an update on US housing prices, some third-tier PMIs, jobless claims and Treasury supply.