In a time when record low volatility has spawned a cottage industry of vol and Vix experts, with analysts desperate to explain either why volatility is where it is – here the simplest explanation is not only the record injection of liquidity by central banks pushing risk assets to all time highs but the fact that even hedge fund are barely trading as we showed last week…
… or where it will be next, even though there is no causal link between backward-looking implied or realized vol and future events, few have come up with a comprehensive analysis or theory of which volatility metric is relevant or appropriate when discounting risk inflection points.
One such attempt, one of the better ones we have seen, comes from Deutsche Bank’s Dominik Constam who in his latest Global Market Strategy letter believes he has found what may be a fulcrum predictive vol indicator which, as he writes overnight, is “an amber warning sign that momentum in stocks might be peaking over the coming months.“
As Konstam simply frames it, “in general equity prices are negatively correlated with volatility, which is consistent with an emphasis on protection and levered exposure to the upside. Rising prices are associated with falling volatility and falling prices with rising volatility. Rising (and expectations of rising) prices convert call exposure into the underlying and reduce concern for the need for protection. Volatility demand is satisfied at lower volatility prices. Falling prices creates more concern for protection.”
That – absent any reference to Greek letters, to central banks, to CTAs and risk parity funds, or to vol ETFs – is about the simplest, and most accurate explanation for why vol is where it is at any given moment. What does it mean for the future?
Spikes higher in correlation, either much less negative correlation or positive correlation therefore appear to be related to mature bull markets. The chart below shows change in correlation versus a year ago and there are coincident or near-coincident peaks in momentum viz June 2000, June 2006, October 2007, October 2009, March 2011 and March 2014. The move from extreme negative toward positive correlation likely reflects a causality whereby the demand for call exposure gives way to demand for put exposure as investors become invested in a rising market and more fearful of a turning point. This is reflected in a positive correlation between put-call volume ratios and the change in correlation.
However, this time something has changed:
It is therefore interesting that as volatility has remained low, the put call ratio has been falling as investors seek exposure to the rising SPX (buying more calls relative to puts). Moreover this has coincided with a sharp move higher in correlation momentum from a very negative -1.22 in March 2016 to the current +0.19 in April 2017 (correlation itself is still quite negative at -0.74 but it is the shift in momentum that we care about).
Konstam’s conclusion: “This is an amber warning sign that momentum in stocks might be peaking over the coming months.”
Which, of course, will be true if “this time is not different”, however when it comes to volatility, there are two problems. As we showed last August when we demonstrated a recent analysis by Horseman Capital’s Russell Clark, “The VIX Is Now Broken” and furthermore, a recent scientific study has confirmed that VIX is also manipulated. As such any assumption, current or future, that vol will act in a “rational”, market efficient manner, especially with the ECB and BOJ continuing to inject a record amount of liquidity into the system, may prove not only self-defeating but become a feedback loop whereby those who go long are forced to cell, pushing Vix even lower, making the divergence from “normal” that much greater.
Incidentally, the best catalyst for a spike in vol may be far simpler: Trump is coming back. After all it was Trump that unleashed a nearly 6 sigma move in numerous vol metrics less than two weeks ago; it is therefore safe to expect that his return to the US will provide even more volatility fireworks in the days and weeks to come.
via http://ift.tt/2r9zx8t Tyler Durden