Authored by Jim Strugger of MKM Partners
Death by Theta
Even the most skeptical among us have to be impressed by the rip higher in U.S. equities over the past week. Absent an obvious positive catalyst, the S&P 500 Index (SPX, 2090.10) jumped 2.5% after flirting with lows since March and a potential test of the 200-day moving average.
More broadly, the SPX is just revisiting the top end of its range back to late 2014 while equity volatility has shifted back to a trough though importantly without having descended to a level that suggests a structural change in the high-volatility regime.
Still, there is little doubt that if stocks do manage to break out and sustain fresh highs than the broad swath of volatility metrics will collapse to levels more indicative of a low-volatility cycle. The period dating back to last August will have been an anomaly relative to historical regimes that have lasted upwards of five years. We are skeptical of that outcome and see support from measures of crossasset and geography risk that remain elevated (GFSI Index in left graph).
As of next week, the U.S. economic expansion will reach its seven year anniversary. The prior three cycles since 1990 averaged 95 months in length measured from trough to peak. That puts the current cycle just shy of a year from eclipsing the mean duration. As MKM Partners Chief Economist Michael Darda points out, business cycles historically survive for around two years once the Fed begins tightening. If the U.S. cycle is late in its expansion then it follows from precedent that volatility broadly but more specifically U.S. equity implied volatility should remain structurally elevated into and through an eventual recession (and likely bear market) before subsiding once the next sustained recovery has begun.
That is precisely why we have struggled with the idea that the high-volatility regime intact since last August may truncate at less than a year. If our reasoning is correct and volatility remains structurally elevated, it follows that the recent three-month cyclical trough, as the longest such period on record, is statistically unlikely to last much longer.
Admittedly, it doesn’t feel that way. Stocks have displayed impressive buoyancy over the last couple of months when pressed lower even while the SPX remains contained within its range back to late 2014. Of course, market psychology can turn on a dime and we can’t help but to see underlying instability amidst this recent market strength. That suggests a dislocation is likely prior to equities escaping to a new all-time high.
For those looking to get directionally longer, we prefer synthetic exposure which can be had simply via outright calls where implied volatility is suitably low rather than by deploying significant capital at the top of the range. While it is tough to push hedges and long volatility given the theta burn from prior recommendations, we still think clients should retain a healthy dose of skepticism about how much longer markets can ward off a bout of instability.
via http://ift.tt/1qP7kQ3 Tyler Durden