“The stock market isn’t the economy. The economy is production and jobs, and there are shortfalls in virtually every sector of the economy.”
-Janet Yellen (Washington Post)
In a previous Inside Volatility we highlighted the French Revolution and the potential shifting of volatility regimes. In Charles Dickens' magnum opus, A Tale of Two Cities, he documents the French Doctor Manette after his years of imprisonment during the Reign of Terror. The novel’s beginning is an interesting lens through which to see the dichotomies of today’s market environment:
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity…we had everything before us, we had nothing before us – in short, the period was so far like the present period…in the superlative degree of comparison only”.
Source: Opportunity Insights
We remain in the midst of a global crisis as the impact of COVID19 infections continues to spread. As a result, we are experiencing an income crisis for a wide swath of the population. Noted in the above chart, the labor market decline was most catastrophic on low-end earners. Those jobs have also been the slowest to recover.
The U.S. economy is highly consumer-driven; our Gross Domestic Product (GDP) levels are guided primarily by consumer spending. The “V-shaped” recovery in retail sales data has been a boon to the bull market narrative. There is, however, legitimate concern over the potential impact if the Congress and Executive branch are unable to hammer out a compromise on extended unemployment benefits.
The additional COVID-related unemployment benefits (+$600/week) ended in July. The federal government paid out $18.4 billion in benefits in the first 10 days of August. By contrast, over the same period in July, they paid out $35.4 billion. Based on retail sales data, it appears much of the CARES stimulus funding went back into the economy. Therefore, this sharp decline in stimulus payments is positioning to negatively impact the retail and the broader economy even further.
Fiscal and monetary stimulus has undoubtedly dampened investor’s fears over the past few months. This is evidenced through the significant decline in realized volatility in the S&P® 500 Index over the past five weeks. In mid-to-late July, 30-day historical SPX® vol measured in the mid-20s. As of August 20, that same measure fell to 11.2 while the Cboe Volatility Index® (the VIX® index) in mid-to-late July was roughly in line with 30-day historical vol, measuring around 25 on average. Interestingly, despite the continued attenuation of realized volatility, the forward-looking measure (VIX) remains over 20.
The VIX futures term structure has been in contango, with front-month futures at a discount to longer-dated contracts since early July. The structure has steepened demonstrably over the past few weeks. Many market watchers and volatility traders key in on the spread between the front month future and the second month contract. Some exchange-traded products (ETPs), most recognizably VXX, are designed to track that relationship (Month 1/Month 2) and roll the exposure daily.
VXX (long volatility exposure) faces headwinds in a contango environment as short volatility players often look to capitalize on the “roll down” (convergence) trade with a “normal” term structure.
Here is a visual of the relationship between what was the Month 1/Month 2 spread (Aug./Sept.- Blue) and the current Month 1/Month 2 spread (Sept./Oct.- Green). The August VIX futures expired and cash-settled on August 19 at 21.80.
Source: Cboe Global Markets
Late last year, Cboe® listed further dated VIX futures ahead of their typical cycle as market participants clamored for tradeable tools to potentially offset perceived “election risk” or express a volatility sentiment around the U.S. Electoral calendar. Since their listing, the October VIX futures—which reflect 30-day forward volatility expectations from their expiry date and incorporate the early November Presidential election—have mostly traded at a premium to the September contract.
While that is not unusual, the relative width in that specific spread has been. The front of the VIX curve has been steepening whereas the middle of the term structure (months 4-7) has remained relatively flat. Furthermore, longer dated VIX futures have traded at a premium to their longer-term averages since the early 2020 selloff. One might infer that near-term concerns have largely subsided, but the market continues to price in the potential for volatility to remain elevated well into 2021.
During the height of the March sell-off, the Sept./Oct. spread inverted, but in recent weeks and months the spread has continued to widen. It will be fascinating to watch this relationship as we move closer to the general election.
Source: Daily Shot/UBS/Morgan Stanley/Bloomberg
The visuals above contextualize the market’s expectation for future volatility at this point in an election year. The graph on the left shows the Sept./Oct. VIX futures spread in mid-August during the current and last four general elections. The one on the right depicts expected monthly SPX ranges based on relative VIX futures levels over the same electoral cycles.
The blue bar in the second graph highlights the implied SPX move in the November cycle (based on October VIX futures). The current VIX futures are pricing an 8.8% SPX range around the U.S. election. By comparison, in 2008 (McCain/Obama), the forward-volatility expectations priced an up/down range of 6.5%. In fairness, far more “fear” was priced into the market a month later when Lehman Brothers filed for bankruptcy (9/15/2008).
On August 18 of this year, the S&P 500 moved beyond its February 19, 2020 intraday highs for the first time. The alacrity of the S&P’s recovery makes this the shortest bear market on record. Big tech continues to lead the way. Consumer discretionary has also markedly outperformed over the past six months.
Companies like Amazon, Nike, Starbucks, Target, and Dollar General arguably benefited from the enhanced unemployment benefits (CARES Act). The largest consumer discretionary ETF (XLY) made new all-time highs on August 19. Recently some of the hard-hit financial, industrial, and small-cap names have been playing catch up. The Nasdaq Composite and 100 also set records on August 19.
As the “dog days of summer” bleed into “back to school” the question becomes whether the market has appropriately discounted the risks ahead. Obviously, the world as it stands is a decidedly different one than the last time the S&P 500 flirted with 3400. One relative constant has been the premium in the October VIX futures contract. We’ll see how it’s reconciled like all other things….in time.
Source: LiveVol Pro
“I learned from him that often contradiction is the clearest way to truth”
“Volatility is an Instrument of Truth. Regardless of how it is measured, volatility is the difference between the world as we imagine it and the world that exists. We only prosper if we relentlessly search for nothing but the truth, otherwise, the truth finds us through volatility”.
-Chris Cole of Artemis Capital
- Apple $2 trillion market cap. One year ago ~$90 billion
- TSLA market cap ~$350B. One year ago $40 billion
- Dollar Index at the lowest level since mid-2008
- Lumber futures all-time high and up 180% since April
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