Cboe Global Markets

Inside Volatility Trading: Market Cycles

Kevin Davitt
March 9, 2021

“All this happened, more or less.”

Kurt Vonnegut - Slaughterhouse-Five

March 5, 2009. My sister welcomed my first niece into the world. March 6, the legendary Phish returned to the stage after five years away and the S&P 500® Index measured 666. Unusual if nothing else. March 9, the markets began to turn.

For the previous decade, I had been trading equity, ETF and index options on Cboe and Philadelphia Stock Exchange (PHLX). The exchange dynamic changed dramatically between the late 1990s and early aughts. The Chicago Mercantile Exchange, Chicago Board of Trade (CBOT), and others demutualized and became public for-profit entities. Cboe was working toward that goal, which came to fruition in June 2010 with an IPO.

The once provincial derivative markets that had been dominated by entrepreneurial individuals and groups were going mainstream. The technological advances that occurred in the 90s democratized investing and reduced barriers to entry. Technology made it possible to alter the "exchange model."

Big Cycles, Little Cycles

Markets cycle, and a new cycle began in early March 2009. There have undoubtedly been periods of turbulence in the intervening 12 years. The uncertainty around European Sovereign debt roiled markets in 2011. Concerns about Emerging Markets and the Chinese currency devaluation rattled investor’s confidence in late 2018. To date, global markets continue to grapple with anxieties related to the COVID-19 pandemic as we make progress toward a new normal. 

The S&P 500 Index Through the Years

Source: Yardeni Research

The big cycle of the past 12 years could be characterized by a return to growth, stimulated in no small part by historically low interest rates. There is a relationship between fixed income yields and equity markets. They compete for finite (albeit very significant) pools of capital. Low yields incentivize greater risk. They also tend to spark consumption.

Since 2011, the cycle has been mostly dominated by low levels of realized and implied equity volatilities. Nearly all macro declines have been shallow. 2017 was one of the least volatile years for the S&P 500 Index since its inception on March 4, 1957. The largest peak-to-trough move for the large cap index during calendar year 2017 was 2.8%.

That 2.8% is not referring to the most volatile session for the year, but rather signifies the largest decline from high point to low point for the entire 12 months. Over the same time frame, the average closing value for the VIX Index was 11.1, its lowest annual measure ever.

New Cycle or Continuation?

Nearly one year ago, the VIX Index made a new all-time closing high at 82.69. That level exceeded any closing level during late 2008 and early 2009. Since then, many markets have regained their footing, aided by monetary and fiscal stimulus on the part of central bankers. Has a new cycle begun or is this a continuation of a sustained bull-market run? The velocity of last year’s decline and rebound make that a legitimate question.

Central bankers have used a remarkably similar playbook in 2020/2021 when compared to 2008/2009. During Jerome Powell’s recent testimony before Congress, he reaffirmed the Fed’s commitment to bolstering the economic recovery and labor markets in the United States.

Commodities are once again booming. Equity markets are 3% off all-time highs. The U.S. housing market has been very hot going into what’s typically the most active time of year for buyers and sellers. In fact, according to data from the Case-Shiller U.S. National Home Price Index, last year was one of the strongest ever for U.S. housing. The year-over-year increase in average home prices was greater than 10%. Housing and related activity accounts for roughly 16% of U.S. GDP. 

S&P Case-Shiller U.S. National Home Price Index from June 2007 - November 2020

Source: Compound Advisors/Charlie Bilello

Volatility Markets

Volatility markets, on the other hand, tend to move inversely to their reference assets, which do not reflect the sanguine attitude. Most data quantify historical events or changes, but options prices reflect potential future volatility.

The era of persistently low levels of implied volatility (VIX Index) engendered meaningful growth in structured short volatility trades. For many years that approach was generally rewarded, but there was a shot across the bow in February of 2018.

The languorous tendencies of 2017 unwound swiftly. Interest rates moved higher. Fed Chair Powell rattled the markets further in October 2018 when he indicated the central bank was “a long way from neutral” on rates. On December 20, 2018, Powell assuaged investors (after a 19.8% S&P 500 drawdown) when they raised rates for the final time. The connection between low rates and strong equity performance was on full display.

As concerns about the pandemic spread, on March 3, 2020, there was a 50% reduction in Fed funds. Less than two weeks later on March 15 the Fed cut rates a full percentage point (to effectively zero), as they had done in 2008/2009. Their efforts arguably mollified the markets. Rates moved back toward historic lows and equity markets/asset prices found support. However, if you evaluate today’s implied volatility levels for nearly any major equity index, they have not returned to levels that one would consider “normal” in the post-Global Financial Crisis world.  

The VIX Index from 2017 - 2021

Source: Cboe LiveVol Pro

For the past 12 months, portions of the U.S. and global economy have been severely impaired. Segments are staggering back to life, but many remain below capacity. Unemployment is well above the 3.5% level from February of last year. Incomes have been bolstered by unprecedented monetary stimulus from Congress. There will likely be another round in the coming weeks that could find its way into consumer spending.

Investors are historically most concerned about “the big cycle” because they tend to be passive long-term allocators anticipating the equity market will move higher over many years. Avoiding a 1973/1974 (inflation-driven) 48% decline in the S&P 500 Index is much desired. The broad market didn’t surpass the 1972 highs again until the early 1980s. A similar argument could be made about the early 2000 (dot com) 49% decline in the S&P 500 Index.

On the other hand, market timing is difficult in the short-term and perhaps impossible in the long-term.  Ideally there’s some inherent diversification between geographies, sectors, and asset classes. Diversification redistributes idiosyncratic volatility risk. However, nearly all investments are implicitly short volatility positions.

  • Long equities = Short volatility
  • Long commodities = Short volatility
  • Long real estate = Short volatility
  • Long private equity = Short volatility

Why? Primarily because historically, when volatilities move substantially higher, so do correlations and equities, commodities, real estate and other alternative assets typically sell off in tandem.

This concept reminds me of a point that Chris Cole of Artemis Capital regularly makes in his research: no matter the market, you’re ultimately investing in volatility. You either own short volatility (this is most common) or you are short volatility (typically sophisticated strategies that structure positive volatility positions). In his 2017 work, Volatility and the Alchemy of Risk, Cole posits that “there is no such thing as control…there are only probabilities.” I believe that to be true.  

The Reality of Investing

Source: Twitter (@Chrisophercole)

A global pandemic was a low probability event and one that we continue to navigate. October 19, 1987, Black Monday, was a low probability event; it happened. Buster Douglas defeating Mike Tyson in February 1990 was a low probability event (42 to 1 according to Vegas). The 1997 Asian Financial Crisis was highly improbable. The attacks of 9/11 weren’t something that quantitative analysts likely modeled. Lehman Brothers bankruptcy, Brexit, Donald Trump’s election – all considered implausible by most people.

Models have profound value. The evolution of finance and derivatives in particular, tend toward more quantitative, model-driven trading. Fundamental adherence to a model, however, is almost certainly a detriment. There are no infallible models, and there is no such thing as control. There are only probabilities.

“Improbable things happen a lot.”

Jordan Ellenberg - How Not to Be Wrong: The Power of Mathematical Thinking

Here & Now

The relatively high levels for the VIX Index and the tradeable VIX Index futures and options are indicative of a market that is pricing more significant potential volatility than before Coronavirus. You may agree, you may disagree. But the information is available, useful, and in the case of VIX Index futures and options, helps to potentially manage future uncertainty.

All we have is here and now. Right now, equity markets are pricing in a continued rebound. The S&P 500 Index is 3% below its all-time high that was established three weeks ago. Bond markets are also pricing in continued growth as well as fiscal and monetary stimulus. Commodities are reflective of global growth. The housing market indicates a robust recovery.

Volatility markets demonstrate the potential for greater than “normal” vacillations in asset prices. There’s a potential to profit or to lose money in each of these markets. There’s also the possibility to use derivatives to insulate yourself in the event the future path deviates from your expected path.

Change is a constant. The end of one thing gives rise to the start of another. There are big cycles and smaller cycles. There is historical data that can help us model predictions for an uncertain future. The potential cost of insuring a portfolio against future variance is more expensive than it was just over a year ago. That, too, may change in the coming months, but as cliché as it sounds: it is what it is.

Odds & Ends

Growth versus value worst month since 2000. What does that portend?

For equity bulls, they better hope it’s different this time. In the mid/late 1990s new technologies proliferated and changed the way the world worked. In hindsight, there was a manic period during the last year (1999) that ended poorly for those overly exposed to growth names.

As you can see in the chart below, growth companies have outperformed relative to value for more than a decade. That’s a big cycle. The pandemic work-from-home environment catalyzed a massive move higher in favor of growth. That trend started to reverse in Q4 of last year, with significant capital flows out of growth and into value in February 2021. That cycle warrants attention. 

Style Ratio: S&P 500 Growth Price Index Divided By Value Price Index

Source: Yardeni Research

The correlation between inflation expectations (represented by the U.S. 10-year breakeven rate) and the S&P 500 Index has been very strong for the past year. Will inflation expectations continue their advance? At what point could inflation become a concern given debt levels and the competition between fixed income and equities for capital? Are we at that point in the cycle?

S&P 500 Index (RHS) vs. U.S. 10-Year Breakeven Rate (LHS)

Source: The Daily Shot

Risk parity funds (RPFs) have also performed well for much of the past year but suffered during the late February selloff in bonds and equities. Risk parity approaches tweak the traditional 60/40 portfolio on a risk-weighted basis. Investopedia explains it quite well. The goal is to reduce overall exposure to risk, but when correlations strengthen, as is the case during most “risk-off” markets, the prospective value is diminished.

Is that a sign of more trouble to come? Last year, many RPFs held up in late February, but when the equity/bond correlations went positive in early March, they lost significant value.

On March 5 my first niece will turn 12. She’s an amazing young lady. Happy birthday to Margaret Nolan Duffy. May your future path be brighter than you’ve ever imagined.

Happy 64th birthday to the S&P 500® Index.

“In my younger and more vulnerable years my father gave me some advice that I’ve been turning over in my mind ever since.”

F. Scott Fitzgerald – The Great Gatsby

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