US equity market volatility is back. The VIX closed today at 14.2, which is the 7th highest ending price this year. The “Fear Gauge” is up 13% in the last month and the S&P 500 is down 74 basis points over the same period.
Tempest in a teapot, or something bigger? I believe the latter, mostly because of the way the current VIX rally has filtered through various industry groups and asset classes.
- Point #1: the “VIX of” US large cap tech stocks is up 45% over the last month, versus the 13% rally in the VIX. That’s the largest jump in sector VIX across the entire S&P 500 and speaks to market concerns over sector valuations, earnings power and how “crowded” that trade has become.
- Point #2: the “VIX of” small and mid-cap stocks didn’t rise as much as that of large caps. Large caps have been leadership this year, so that tells us options traders are concerned about those stocks having run too far, too fast.
- Point #3: Valuation matters. The VIX of large cap Health Care stocks (one of the few bargains in the S&P 500) barely budged last month, up only 14%.
My conclusion: the rally in volatility is not over. It may need fresh headlines to really get it going, but the last month was an important “Tell".
My very favorite story from the world of modern science centers on a meteorology professor at MIT. Fifty-plus years ago Edward Lorenz was plugging data into a computer and (because this was 1961) he took a coffee break while the system compiled his request. When he returned, he expected to see results similar to an early cut of the data.
Instead, everything was different. The only change he had made was to round off one of 12 variables in his formula from 0.506127 to 0.506. That abbreviation was enough to dramatically change the weather forecast for a 2 month window.
Lorenz published his observations in 1963 and over the years they have acquired a nickname: the “Butterfly Effect”. You know the idea – that the flapping of a butterfly’s wings in Thailand (that 0.000127 difference) can cause a hurricane in the Gulf of Mexico. Here is an excellent article in the MIT Technology Review if you want to learn more: https://www.technologyreview.com/s/422809/when-the-butterfly-effect-took…
Traders and investors know the Butterfly Effect at a deeply intuitive level. They are those distant events that never make it onto your radar screen until you notice the eye wall of a storm heading your way. We spend countless hours looking for butterflies.
The central mechanism for pricing “Butterfly Risk” is not really stock levels; rather, it is options pricing. Implied volatility is the one unknown in the equation markets use to price listed options (remember Black-Scholes?). No obvious butterflies in the air? IV is dirt cheap. A whole kaleidoscope (that’s the collective name for them) of butterflies swarming around, and IV gets really expensive.
The best known measure of market-wide Implied Volatility is the CBOE VIX Index, and it has been marching higher over the last month. From a close of 12.5 on March 21st, it got as high as 16.0 on the April 13th. It ended today at 14.2, the 7th highest close of the year.
Ask any options trader what you do during a “Vol spike” and they will uniformly tell you “Fade it”. That’s because they have seen 6 notable spikes in the VIX since 2010 to levels over 20 (the long run average). And each and every one was a buying opportunity for stocks and a selling opportunity for options based volatility.
The name of the person who first said “This time is different” is lost to history. That is probably a testament to the accuracy of Darwin’s ideas. Over the long term, very little is ever different when it comes to human behavior. History (at least apocryphally) does tell us that Baron Rothschild said “Buy when there’s blood in the streets.” The second part of that phrase is less well known: “Even if it is your own.”
Still, we have to remember that at 14 the tide of the CBOE VIX Index is not yet back to that 20 level where real “Fear” (and a buying opportunity) begins to appear. Every month we tear apart the VIX into its component pieces – the “VIX of” every sector in the S&P 500 and other asset classes as well – to see exactly how “Fear” is ebbing and flowing. Here are our key takeaways:
Large Cap Technology stocks have seen the most notable increase in their “VIX” of any sector in the S&P 500. At one level, this makes sense since it is also one of the best performing sectors. Investors are using options to hedge their winning positions. Fair enough.
What is surprising is the magnitude of the increase in the Tech VIX: +45% over the last month. The real VIX is only up 13%. Even taking into account the entire options chain for the S&P 500 (the VIX only looks 1 month out), the Implied Volatility for the SP 500 is up 35%.
What has options buyers so concerned about Tech stocks here? Yes, they have higher betas but the explosion in options risk pricing seems out of whack with that fact. I take it as a “Tell” – that investors are overweight tech stocks (and hence need options based protection) but have a fundamental concern over valuations and earnings power (and hence REALLY need options based protection).
The VIX of small and mid-cap stocks did not rise as much as that of the S&P 500 this past month. Strange, because those (like Tech stocks) tend to have higher betas. And yet the all-in VIX for small cap stocks only rose by 24% last month, and mid-caps by 29%. As mentioned, the all-in VIX for the S&P 500 rose by 35%.
The upshot here: as with tech stocks, investors are overly crowded into large cap stocks because they have been working this year and small/mid hasn’t. As a result, options-based “Insurance” gets more expensive when volatility picks up.
Sector valuations do actually matter. Take Health Care, for example. Over the last month the group is down more than the market as a whole (down 1.2% versus -0.74%). And yet the VIX of large cap health care was only up 13.7% last month – far less than the 35% lift for the S&P 500.
My bottom line is that this data shows that near term volatility is not over yet. Let’s face it: at 17.5x, the S&P 500 is not cheap. As we’ve noted in prior reports, its performance year to date is quite narrow and based on a handful of Tech names. The “Trump Trade” got a lift today with some fresh chatter out of Washington, but investors know the path from campaign promise to legislation is long and hard and fraught with setbacks. The options price data we’ve reviewed here fits that narrative, with large VIX spikes for the Tech leadership group but little movement in cheap sectors or market cap ranges that haven’t been working.
The kaleidoscope of butterflies may never show up, but markets may exhibit a little more lepidopterophobia (yep, fear of butterflies) very soon.