With the current market environment pricing in very low volatility moving forward, one can argue there is too much “complacency” towards stocks. Historically, corrections are sparked with this sort of setup.
You all know that I have not yet been convinced that it’s time to take a defensive stance regarding U.S. stocks, or stocks internationally for that matter.
But we always want to look at the evidence, including data that might be outside of my particular wheelhouse.
Andrew Thrasher is the person I turn to whenever I have questions about Volatility, and more specifically the CBOE Volatility Index (VIX). I know he tracks the data much more closely than I do and he does a good job of simplifying what may seem like complicated concepts.
Andrew is also the winner of the 2017 Dow Award for his paper Forecasting a Volatility Tsunami.
I spoke with him about the current volatility regime, the VIX curve looking out into early 2020, and how he incorporates breadth data to supplement his volatility analysis. It seems like the perfect time to talk about Volatility so I wanted to share some of what he had to say.
The Ultimate Sentiment Tool
Why is volatility so hard to chart?
Just because volatility moves every day, it doesn’t mean we can view it the same way we would Apple Stock. There is no supply and demand of spot VIX. It’s a statistic.
When spot VIX is at 12, it’s telling you what the options market thinks for the S&P 500 over the next thirty days…
We can’t say that VIX has hit support or resistance. Those are things that are defined by supply and demand. It doesn’t have any of that. It’s a statistic. It’s a percentage.
I see people trying to put VIX in a box that they’re used to working with for stocks or bonds or ETFs or commodities, or what have you.
The way I view Volatility is that it is a tool to evaluate the market… It’s the ultimate sentiment tool.
Right now, we have an extreme amount of complacency in the volatility market where basically no one expects volatility to do anything in the short term. Which I think looks like an over complacent market, based on the shape of the volatility curve.
Is a Repeat of 2018 Coming?
Remember 2017? Volatility was so low for so long. What are the chances that we see that again?
That is what a lot of people point to. ’17 is just engrained in people’s mind… But that I think is the exception to the rule… There’s so many other instances where we’ve seen some periods of releasing pressure in volatility where we see these spikes of 20 or 30 percent up – which is normal market behavior.
Just because Volatility spikes higher does not mean we’re seeing a repeat of ’07. These releases of complacency, this sort of resetting of the clock, are normal market behavior.
We saw that in January of ’18 [see chart] where we had a larger release of pressure, but basically a month later the market was back to new highs.
A lot of people recently have been saying that the VIX is at a 3-month low, and because of that it has to spike higher. Historically that’s just not what happens. So many people don’t look at the market history.
Typically, as you can see from this chart, when the VIX spikes it’s doing so after it has already started to increase. We don’t typically see massive spikes from record lows…
At the moment, we have started to see a positive correlation between Volatility and equities as the market starts to pay attention to a little less bullishness and the possibility that Volatility may begin to increase… and then you start to have those spikes that we’ve been used to seeing forever.
And More Importantly, When?
What are we missing??
Volatility is where my eye always goes. I very much think Volatility is getting underpriced. I told you earlier that I though it looked very similar to a January 2018 kind of environment… The way sentiment looked, the way price action appears and the way Volatility was playing out based on the hatred for long volatility – everyone was shorting volatility…
I don’t think we are going to see the same Volatility explosion that happened at the beginning of last year, but we’re seeing a lot of traders shorting volatility… to the extent that it’s gotten a little stretched.
When you talk about positioning, I take it you are referencing the hedgers versus the speculators, so the hedgers have the biggest net long position of all time in Volatility. But the last time they had a position of this magnitude was in October of 2017 – and we didn’t get that spike until several months later. They could be, and they have been, very early. So who’s to say that they’re not just early again?
What will be the final catalyst? Will it be a Trump tweet, China tweet? I don’t know, don’t care. I’m just trying to evaluate the market data and right now it’s very much slanted towards everyone being short Volatility and that’s just not a song that plays forever.