- A bubble in low volatility that expanded a great deal in 2017 is now bursting, according to derivatives strategists at Bank of America Merrill Lynch.
- According to them, this marks a regime change that will change the very nature of the market as we know it today.
- They offered evidence for why market turbulence is poised to become the norm, as well as an investing strategy to profit from it.
The dog days of low volatility in the stock market are over.
That’s according to derivatives strategists at Bank of America Merrill Lynch, who are convinced that the sleepy days that prevailed in 2017 are long gone, and a major regime shift is underway. In fact, in their 2019 outlook note to clients, they go as far as describing the old status quo as the „low-volatility bubble.“
This call not only hinges on the implosion of securities that were designed to produce the inverse returns of the CBOE Volatility Index, or VIX. Notably, the Credit Suisse-backed VelocityShares Daily Inverse VIX Short-Term ETN (XIV) blew up on the same day in February that the so-called fear gauge had its biggest spike on record.
The strategists observed several other underlying trends that survived that trainwreck but are now on the brink of their own reckoning.
„Looking at the world through the lens of volatility, we see markets that are unsustainably out of sync, fragile, and overall underpricing the risk of regime change,“ Benjamin Bowler, the head of global equity derivatives research, said in a note.
„History strongly suggests that the market we see today won’t exist by the end of next year.“
A number of significant changes are changing the nature of the market, with more to come.
First, investors‘ strategy of buying the dip — a safety net of sorts that reversed many sell-offs during this bull market — is no longer effective.
Bowler observed that in 2017, the speed at which the S&P 500 recovered from drawdowns climbed to 90-year highs. That explains why in the same year, the benchmark index recorded its longest streak ever without a 5% pullback, and elucidates why the VIX languished at a record low.
The detailed chart below shows some of the key moments when the strategy worked — and failed — during this bull market.
Secondly, the Federal Reserve’s leadership handoff from Janet Yellen to Jerome Powell has been consequential for the stock market.
„Powell has not stepped in to protect markets,“ Bowler said.
Yellen, however, provided what Bowler describes as a backstop by delaying interest-rate hikes in September 2015. Fast forward to today, the Fed is widely expected to proceed with raising interest rates at its December 18-19 meeting amid the sell-off in stocks and concern about an economic slowdown, although a Wall Street Journal report Thursday said a wait-and-see approach in 2019 is on their radar.
Besides the Fed’s leadership transition, there’s a bigger policy shift underway, as the Fed moves further away from crisis-era strategies. Bowler said it was only a matter of time before the accommodative policy that created „the largest volatility depression in history“ was removed and the bubble began to deflate.
For proof that the direction of Fed policy is poised to rock US markets, Bowler points elsewhere. Emerging-market stocks and currencies are most sensitive to Fed policy, and the volatility in both started to rise mid-2017, followed by the US equities correction in February.
The final piece of Bowler’s evidence that the volatility bubble is bursting dates back to last year. He observed that during the market’s unprecedented calm, sell-offs were smaller than rallies because investors were more scared of missing out on upside moves than losing money in wipeouts.
But a reversal has taken place this year; sell-offs are more brutal than rallies because investors are disproportionately worried about losing money in prolonged sell-offs. That’s taken Bowler’s gauge of average returns on S&P 500 down days versus up days to the highest level in over 30 years in 2017.
Market activity since late-September hasn’t soothed their newfound worries, amid a long list of concerns from higher interest rates to Fed policy and tariffs. Moreover, most strategists at major Wall Street firms forecast that volatility to persist in the new year.
Bowler offered a trading recommendation to take advantage of the changing regime: own long-dated equity volatility:
„Trades: Accumulate longer-dated S&P 500 (SPX) and Russell 2000 (RTY) forward-starting variance, e.g., long SPX 12m24m (~Dec19/Dec20) or 18m24m (~Jun20/Dec20) forward variance + similar tenors in RTY.
Why? Longer-dated US equity vol can provide attractive risk-reward late cycle and has significantly lagged 2018’s reset higher in the VIX. SPX 12m24m & 18m24m forward variance screen best with ~6x upside vs. downside. RTY forward variance is less liquid but is near 10yr+ lows despite fundamental risks faced by small caps.“
Source: Business insider