There are certainly a number of people scratching their heads as to why there was such a big move in implied volatility on Friday.
This seems fair as there is not one catalyst to cause such a big move in market, but rather a collection that has finally seen the S&P 500 break its 2190 to 2150 trading range and traders rushing to hedge portfolios. The phrase ‘hedge because you can (and it's cheap), not because you have to’ was certainly something that investors should have thought about last week, however its worth remembering the 40% move in the VIX was grossly exaggerated by perhaps the biggest net short position ever seen in the VIX futures.
As soon as the S&P 500 broke below the lower limits of its recent range of 2150, the algo’s went crazy and the computers widely took over markets. Any stock which had benefitted through most of 2016 from having a higher yield was quickly sold, as bond yields rose and the discount factor used in working out the net present value for future cash flows of equity holdings increased. This is an issue that will no doubt flow into Asian markets.
The moves in equity and risk sentiment more broadly seem to be a culmination of less supportive central banks, steepening yield curves pushing up longer dated bonds and the impact this has on expensive equity valuations. There is even a view, which I share, that if the US Federal Reserve (Fed) are really hell-bent on raising this calendar year when the data doesn’t support it, it is because they are doing so more out of concern about overheating valuations in corporate bond markets and therefore lower dislocations in various markets. So should we be concerned too?
The ASX 200 has actually become somewhat of a leading indicator behind the moves of late in markets. The index, with its highest aggregate dividend yield in developed markets, has been sold since 23 August and if our call for 5249 comes to fruition we would have lost 325 points or 5.8% in the process. Participation has not just centred on the high yielders, but in this time we have seen the percentage of companies trading above their 20-day average falling from 95% to currently stand at 26%. It must be said though that the market is grossly oversold due a technical bounce, although I would be fading rallies into 5330 to 5350. Perhaps Lael Brainard can cool tensions of a near-term hike from the Fed, however given her pessimistic view of late, expect any clear hints of a hike this year (which currently sits at 60%) to be magnified, in turn causing the global sell-off in fixed income to ramp up.
Putting the trading hat on, it’s good to see a bit of life back in these markets. Where there is volatility, there is dislocation, which breeds opportunity!