Is it time to book gains in U.S. equities?
It's worth pondering. The Nasdaq is up 9.6% and +5.3% from its November and December lows. The real money in macro markets is obviously made by selling things that are overbought and buying things that are oversold. On that score, checking in on the investor's expectations of future volatility in equity markets is deeply instructive. It provides a nice read-through on consensus.
FIRST, SOME BASIC DEFINITIONS:
- Realized Volatility = Historical Volatility (the market fluctuation of an asset over a given time period)
- Implied Volatility = Future Volatility (the volatility that investors expect in the future based on current options market positioning)
Applying these principles helps understand whether prevailing investor sentiment is one of complacency or an outlook that is overly pessimistic.
Basically, investors fearful of future fluctuations pay up for downside protection. In this instance, you would see higher implied volatility versus realized volatility. This is called the volatility premium (where implied volatility exceeds realized volatility). Conversely, a volatility discount happens when implied (future) volatility is below realized (historical) volatility.
How to Trade when the premium or discount stretches to extremes
This is typically a kneejerk reaction that suggests a move is most likely overdone. Consider the Chart of the Day below. It shows implied versus realized volatility for the Nasdaq over the past sixteen months.
As you can see, before the presidential election in November, investors were uncertain about a Clinton or Trump win and piled into options contracts that offered downside protection. The implied volatility premium stretched to almost 70% above realized.
But then, in the wake of Trump's win, exhuberance set in. Expectations of future volatility started moving down and the volatility premium normalized. (Note: This is why we got bullish on the Nasdaq towards the end of November).
What happened? Formerly fearful investors capitulated and bought stocks. Since Election Day, the Nasdaq is up +7.1%. The volatility premium is now +9.1% versus the 3-month average premium of +15.3%.
Interpreting Investor's Volatility Expectations
Here are three questions (and our answers) to think about from Hedgeye CEO Keith McCullough (in today's Early Look):
- Do you consider rising implied volatility premiums (i.e. pre-Election Day rise in Nasdaq options contracts) a bullish or bearish indicator? I think rising implied volatility premiums are encouraging me to believe that being bullish is not consensus
- Do you consider falling implied volatility premiums (i.e. post-Election Day move in Nasdaq options contracts) a bullish or bearish indicator? I think falling implied volatility premiums mean I’m getting paid on the long side and should book some gains
- And when you flip to implied volatility discounts, do you think rates of change matter as well? I think that when implied volatility falls and trades at a relative discount, I have no business calling my longs contrarian
In other words, as investors get more fearful of future volatility, at the right level, that's when you get long. As implied volatility falls and formerly skittish investors capitulate (i.e. pile into equities), you cover your long position and book gains. When volatility is at a discount, investor complacency has set in once again (so don't get long, stay out of the way!).
What to do now: The Current Setup in U.S. Equities
At the current volatility premium of +9.1% on the Nasdaq, here's some advice on specific levels from Hedgeye CEO Keith McCullough:
"I’d much rather buy the Nasdaq when implied volatility premiums (on 30-60 day durations) are running +15-30% than here."
There you have it. Book gains in the Nasdaq and wait for a consensus freak-out once again to get long. That’s what makes the S&P 500 a more interesting “BUY” now on pullbacks. Its 30 and 60 day implied volatility premiums are +16-24%.