While it is probably not a pressing issue today with the Nasdaq just entering a bear market, and more than half the companies in the S&P well below 20% as the broader market has clearly peaked, Deutsche Bank’s quants recently published a note describing its favorite market timing indicator.
To determine if it is time to BTFD, or alternatively, to sell the rip, Deutsche Bank quant Ronnie Shah introduces one of his favorite contrarian indicators, dubbed the Variance Risk Premium (VRP) indicator, which measures market overreaction and underreaction to realized risk. In simple terms, VRP is the difference between options-implied risk (i.e., the VIX index) and realized risk (i.e., the actual risk in the market, historically measured over the last month).
If VRP is high, the biggest German bank sees this as a buying opportunity for risky assets, like equities and high-yield bonds, and explains his reasoning as follows: when VRP is high, VIX has typically shot up dramatically (i.e., the market is in panic mode). At the same time,
realized risk has probably also risen, but not to the same extent. In other words, the market has overreacted relative to what the actual realized data is telling traders.
Historical research shows that such episodes are good buying opportunities for risky assets on about a three-month horizon. On the other hand, when VRP is low, it tends to be a complacency indicator – investors are failing to price rising realized risk into the market, and as a result, favors selling risky assets like equities.
So it may come as a surprise to those bulls who consider every downtick as an invitation to buy, currently the VRP indicator is at 3.0, less than the long-term average of 12, and suggesting bearish sentiment, i.e., it is nowhere near an “all clear” signal to buy right now.
That said, Shah notes that he mostly pays attention to the VRP when it hits extreme levels (like +/- 2 standard deviations, or outside -10 and 34). It has a ways to go on either side, which means that anyone hoping to jump into the market whether long or short, will have to wait a bit longer.
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