Trying to make some sense of it all
But I can see, it makes no sense at all
Is it cool to go to sleep on the floor?
Cause I don't think that I can take anymore
Clowns to the left of me, jokers to the right
Here I am, stuck in the middle with you

-Egan/Rafferty

Cboe’s Inside Volatility pieces attempt to illuminate the investment landscape through a unique lens whose filters include index options, history, geopolitics…and some music. To wit, 1973 was a monumental year in both the United States and globally.

Some highlights and lowlights from 1973:

  • U.S. ends its involvement in Vietnam with the Paris Peace Accord
  • Annual inflation runs 6.16% (United States)
  • Average Cost of a New Home ~$32,500
  • Secretariat wins the Triple Crown (first horse since Citation in 1948)
  • The Sears Tower (Chicago) is completed in May (tallest structure in the world for 25 years)
  • Watergate Hearings begin and VP Spiro Agnew resigns
  • OPEC announces intent to restrict the flow of oil to countries supporting Israel (Yom Kipper War) and prices for petroleum climb by about 200% triggering “stagflation”

Also of note, in late April of 1973, the Chicago Board Options Exchange® (CBOE) listed call options on 16 different underlying equity products. During the inaugural session, 911 options traded. 47 years later, during an average day about 20 million options trade. Analysts might refer to that as parabolic growth.

Here’s to the visionaries who brought equity options into the mainstream. Here’s to the exchange that pioneered index options in 1983 and that established The Options Institute® in 1985, of which I am now a proud member. It is our mission to educate and advocate for the informed use of derivative products.

Cheers, to the collaboration that brought you the Cboe Volatility Index® (the VIX® index) and eventually VIX® futures and options. Cboe introduced Weeklys℠ in 2005, which now account for more than 50% of options volume in a number of products. Cboe continues to innovate, making markets more transparent, accessible, and understandable to all participants.

Enough about the past, as Professor Galloway paraphrased Lenin in his recent No Mercy/No Malice, “nothing can happen for decades, and then decades can happen in weeks.” The past few weeks have been one of those decades. Here we are stuck in the middle of the range.

The S&P 500® Index made all-time highs in late February just below the 3400 level. A few short weeks later, following a historic selloff, the broad market was down roughly 1200 handles or 35%. As of writing, the S&P 500 is back to 2800, right in the middle of the massive range from February 19 highs to March 23 lows. In an interesting twist of symmetry, we’re two months removed from highs and one month off lows.

The economy and markets are distinct entities with unique, often amorphous qualities. The market, at the moment, seems to agree with the Fed’s St. Louis member, James Bullard who recently contended that a “V-shaped” recovery remains tenable. Or, maybe more to the point, Bullard and the other Fed Presidents believe that there’s few problems that $2.3 trillion or so can’t solve.

Markets are said to be forward looking and implied volatility measures are unequivocally forecasting tools. Broad equity market volatility, as measured by the VIX® Index, has ranged from roughly 14 to 85 since the COVID-19 crisis became front and center. As it turns out, forward volatility measures remain stuck in the middle of that two-month range.

As we’ve pointed out in previous Inside Volatility updates, a VIX® Index measuring around 42 anticipates about 2.625% daily S&P 500 moves (closing basis). Most “newer” option traders are unfamiliar with persistently “high” levels of macro volatility. Since late 2011, there have been a handful of swells in vol, which on the whole, have been short lived. Currently the 1- and 3-month realized volatility levels for the S&P 500 are in the 60s. The narrative is one of ongoing volatility as opposed to episodic.

Staccato events like the Brexit referendum, heightened tensions on the Korean peninsula, and the percolating Trade War with China put (mostly) short-lived bids into the options markets.

Inside Vol April 20 1

Source: Yardeni Research

As you can see in the table below, for the past eight years, S&P 500 selloffs have been relatively muted. The averages DO NOT include the most recent decline, which skews all the calculations considerably. The “typical” selloff has been less than 11% over the course of about two months (calendar days) and the average peak VIX® Index measure is ~30.

Inside Vol April 20 2

Sources: Bloomberg and Cboe

The COVID-19 swoon more than tripled the average selloff, occurred over about one month, and the VIX® Index made an all-time closing high at 82.69 on March 16. Despite the sharpest rally in the broad market since 1933 where the S&P 500 advanced 27% in 15 days, the broad market remains somewhat mired in no-man’s land and volatility remains bid.

Dean Curnutt and his colleagues at Macro Risk Advisors do excellent work in this area. In some of their recent analysis, they point out that options, and the inherent flexibility they provide (“buy v. own”) may make sense despite the relatively high VIX® Index levels.

“While it is not controversial to argue that the truly giant daily swings (three successive days of +/-9% moves in the SPX!) are behind us, we continue to experience regular flare ups that should keep the level of realized volatility in the SPX at a very healthy level.  In turn, the VIX should stay elevated.  The market has logically punted on evaluating the economic data statistics up to this point.  Corporate profit data may be viewed in a similar light, although the performance of financials this week suggests otherwise.  At some point, however, the market must assess the damage. This messy exercise will necessarily be fraught error, entangled with evaluating the efficacy of the fiscal and monetary response along with the moving target that is when and to what extent the economy can reopen.  These matters will not be settled for an extended period of time and the market will tether itself reasonably soon to responding to new information.  The VIX has spent more than a month north of 40.  Only the GFC outstrips this with respect to implied volatility that was so elevated for so long (VIX was above 40 during the 3 month stretch of Oct, Nov, Dec.2008).”

One potential concern involves the eventual “cost” of the interventions that have (for now) stabilized the financial plumbing. The visual below comes from Nomura via The Daily Shot (April 14) and it forecasts U.S. budget deficits as a percentage of GDP. Their expectation calls for deficits of 27.2% (of GDP) during the current quarter, which would exceed the levels from both World War I and World War II.

Inside Vol April 20 3

Source: The Daily Shot/Nomura

From a volatility perspective, the bond market doesn’t seem to be signaling exceptional levels of forward-looking concern. Cboe’s TYVIX®Index, which is a constant measure of forward volatility expectations based on 10-year Treasury Note options, has declined more precipitously than the VIX Index. As of April 16, the TYVIX Index measured 6.46. The average for 10-year bond vol going back 52 weeks is 5.25.

The Index moved from the 4.25 area in early February to its zenith of 16.39 in mid-March. It’s nearly back to the pre-COVID levels despite the yield curve remaining very near its lows (high prices). Again, it’s a testament to a $2.3 trillion dollar firehose as a perceived panacea.

Inside Vol April 20 4
Source: Cboe Global Markets

For a much more nuanced analysis of fixed-income volatility, send your contact information to [email protected] to be included on their updates. For example, in their most recent piece there’s a fascinating breakdown of the synchronized shift in volatility regimes on the part of both the VIX® Index, as well as Treasury vol, on February 24.

Inside Vol April 20 5

Another stat that harkens back decades comes from S&P Dow Jones Indices. This shows the cumulative weight that the top five constituent names in the S&P 500 have in the index. Microsoft, Apple, Amazon, Facebook, and Johnson & Johnson, which have all performed quite well over the past month, now account for the most significant weighting in the Index since the late 1970s. Is this another example of the rich getting richer?

Inside Vol April 20 6

So, here we are stuck in the middle of the trading range with the S&P 500 chopping around the 2800 level. Central banks globally have turned the spigots back on while the Saudis and Russians slow their crude oil spigots. Equity market leadership remains a point of interest in the Isolation Economy. Volatility levels are also searching for a new normal, but to paraphrase the inimitable Thom Yorke:

We might be wrong
We might be wrong
I could have sworn I saw a light coming on

Greenwood/O’Brien/Selway/Yorke


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