Our days were long, our nights were longer
Count the seconds, watch the hour
Although we live on the US Dollar
You and me we’ve got our own sense of time
(Ezra Koenig/Vampire Weekend- Hannah Hunt)
It’s been said countless times and there are constant reminders, but as Fed Chair Jerome Powell remarked on May 13, we’re living through a period "without modern precedent." We’re two months removed from nearly nationwide stay-at-home orders. The most populous county in the United States (LA County) recently extended their shelter in place mandate until the end of July. Large portions of the global economy are either shut in or severely impaired. We’re also three months removed (to the day) from the all-time highs in the S&P® 500 Index.
It can be difficult to grasp the magnitude of what’s transpired over the past 60-90 days. If you’re one of the roughly 30 million Americans that have lost a job because of the global pandemic, perspective is exceptionally difficult to maintain. Here’s a look at the monthly change in Non-Farm Payroll data from Trading Economic that goes back 70 years.
This visual could easily run alongside the definition of “unprecedented.” More than 20 million US jobs lost in a single month.
Shifting to equity markets, here’s a chart that illustrates the SPX® performance year-to-date (top) as well as option volume and 20-day historical vol compared to 30-day implied volatility levels. The visual comes from the LiveVol® Pro platform.
Source: LiveVol Pro
Market watchers are well aware of the fact the S&P 500 experienced a historic selloff in terms of both magnitude and velocity. It was the quickest 20% decline from highs ever. As noted, the Cboe Volatility Index® (the VIX® index) closed at an all-time high of 82.69 on March 16. The broad market reversed course a few sessions later (March 23) and proceeded to mount a historic rally.
On April 24, the SPX closed over its 200-day simple moving average (SMA) for the first time since February 21. For the last three weeks, the broad market has been chopping between its 50-day SMA and the longer term measure with significantly less velocity than in March and April.
10-day realized SPX vol has fallen below 24% for the first time since late February. The 20-day historical measure is also the lowest it’s been since before the month of March. In a related vein, forward /expected volatility as indicated by 1 month SPX option prices has declined significantly. In recent sessions, the implied volatility of 30-day SPX options has exceed 20-day historical levels, which is a much more typical relationship. There’s been significant research on Implied Volatility Risk Premia and we dedicated a blog piece to the topic in late October.
Hedging with index options (and/or VIX futures) has long been an emphasis for institutions and individuals alike. The utility of downside protection tends to become much clearer after risk-off stretches like the past few months. SPX option volume swelled, setting records during the acute portion of the drawdown with put options dominating trade. The demand for SPX puts faded during the rally in late March and most of April. More recently, there seems to be another tick higher in the put/call ratio for SPX options. Perhaps some market participants are worried that the recent rally isn’t sustainable.
Source: Bloomberg and Cboe Global Markets
According to research by Evercore ISI, one of the primary concerns for investors looking ahead is a second COVID wave of infections. Nearly 40% of respondents considered that to be their primary risk. Valuation and geopolitical tensions were mentioned with the second- and third-greatest frequency.
David Tepper, founder of the Appaloosa Management hedge fund, expressed trepidation about the S&P 500's forward PE ratio. Consumer and business spending remains constrained for the foreseeable future. Consequently, future earnings for S&P 500 constituent companies have been revised lower while the market rebounded.
Stanley Druckenmiller expressed similar concerns while addressing The Economic Club of New York last week. He called expectations for a “V-shaped recovery” a “fantasy” and considered the risk-reward dynamic in equity markets as “bad as I’ve seen it in my career.” Both Tepper and Druckenmiller acknowledged the exceptional levels of monetary stimulus on the part of the Federal Reserve and other global central banks. They seem dissuaded as to the ability or efficacy of their efforts to backstop the financial plumbing.
To the last point, for the first time ever, the Fed began buying bond ETF products as a part of their broader efforts to buttress the US economy. They are expected to use $75 billion from the Treasury Department, leverage it 10-to-1 for a total purchasing power (notional) of $750 billion.
The markets are forward-looking vehicles and arguably began pricing the intervention into products like HYG, well in advance. HYG is an ETF designed to track the Markit iBoxx® USD Liquid High Yield Index. Small- and mid-cap companies tend to be riskier and their debt typically falls into the high yield tranche. There was real concern about their vulnerabilities two months ago, which have moderated at least in part as a result of Fed action.
Properly functioning credit markets are akin to the aorta, the largest artery in the human body that pumps blood from the heart to the rest of the body. Companies (and individuals) require access to capital in order to maintain full economic integrity.
Perhaps concomitant, Cboe Futures Exchange℠ (CFE®) has seen meaningful growth in trading in IBHY, a high-yield corporate bond futures product. This product was launched in September of 2018 and has experienced record volume of late. In terms of notional exposure traded on a daily basis in May, IBHY has made inroads. This trend bears watching.
Source: Bloomberg and Cboe Futures Exchange (CFE)
It wouldn’t be a proper volatility update without some term structure analysis. The VIX futures term structure inverted on February 24 and remained in backwardation until May 11. That was the second longest stretch of VIX futures backwardation ever (longest was fall 2008). Below is a visual including Feb. 21 (previous contango), March 16 (steepest VIX structure and all-time VIX Index closing high), and the settlements for VIX futures between May 11 and the 14.
Source: LiveVol Pro
Of note, despite the dramatic decline in expected forward volatility levels since mid-March, macro volatility levels are still much higher than they were before COVID-19 fears escalated . Also, the kink in the futures curve (October contract) disappeared during the pandemic selloff, but has reemerged as we shift toward a “new normal.” In fairness, the October futures now arguably encompass both the next US election cycle as well as the beginning of the coming flu season, which may be unlike any other in history.
According to the Kaiser Family Foundation, between March and early May of this year roughly 78 million people live in a family where someone has lost a job. The population of the United States is about 330 million, so that works out to about a quarter of the US population.
Managing risk, whether in the capital markets or everyday life can be a matter of perspective. Index options afford end users the ability to potentially insulate themselves over a given timeframe depending on their approach. Government programs and Federal Reserve stimulus are providing some backstop for businesses and individuals during this unprecedented period.
Perhaps President Truman expressed it best when he said: “it’s a recession when your neighbor loses their job; it’s a depression when you lose yours.”
P.S. Yesterday the world welcomed a new Sullivan. I’m not sure if it’s Alice or Jack (compliance lead time), but this new addition to the world has some incredible parents. Sláinte chugat Brian & Laura.
Wisdom’s a gift but you’d trade it for youth
Age is an honor, it’s still not the truth…..
Ezra Koenig/Vampire Weekend
Get the Inside Volatility Trading newsletter directly in your inbox by signing up here.