Time Tames Expectations

Although it wasn't going to take much into this week for the VIX to get some love, volatility expectations have gradually been pulled lower since the election of Trump. Perhaps the largest shift since the election has been in January where forward-looking expectations for volatility (implied) have been crushed to nearly unprecedented levels. Below we draw important conclusions from our daily monitoring of key pricing and sentiment variables, much of it derivatives-markets based – We’ll have a blackbook coming in the near-term to discuss our tactical use of many of the factors outlined below. We publish key conclusions ~monthly in cohesion with shifting conditions.

We weigh these various indicators against our own fundamental and top down views to find opportunities where consensus seems to diverge from those said views. To the extent you're interested in a more technical discussion on how we think about capitalizing on the various set-ups ping us back.

In this update we focus almost exclusively on the volatility factor in equity markets broadly, both trending and forward looking. Here are the high level conclusions:

• We flagged compressing implied volatility in our last note at the beginning of 2017 (LOOKS A LITTLE SLEEPY). Whereas after the election, implied volatility was still bid at large premiums to trending realized volatility, particularly in U.S. equity markets, implied vol. has been completely crushed – In other words, implied volatility has followed realized volatility to near all-time lows. We throw some historical context around current levels below.
• Multiple global equity indices have traded in low single digit percentiles from a realized volatility perspective in the near-term – The low vol. environment has spread across the globe and most importantly it has crushed long volatility positions and the term structure to interesting levels regardless of directional views on the market.  
• Another clear-cut signal of positive expectations for equity markets can be seen in volatility skew, with the largest positive shift by far in U.S.- linked equity markets.
• Net Futures & Options positioning and short-interest in equity indices points to a consensus stance that is positive on the margin month-over-month. All sectors have seen a cut in short-interest as % float m/m (ex. Healthcare and Telecom where it was flat), and net futures and options positioning remains extended in Russell 2000 Index + E-Mini contracts.    

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Implied Volatility Premiums:

The takeaway here is that as realized vol. has trended lower for longer in many equity indices globally, the market’s expectation is that this trend will continue far into the future. Time Tames Expectations.

• In using the example of the S&P 500, the first chart below shows an implied vol “premium Factor” which takes the midpoint of realized and implied vol. (in this example it’s 30D realized vs. implied vol. on a 30D contract expiry). It’s an attempt to contextualize the premium for overall levels of volatility. At a 7.2 premium factor currently, the market is right above a July 2014 low of 6.9 and right above the prior cycle low of 7.5 in January of 2007. This series has been smashed in a straight line for three months straight.
• Implied vol. has moved lower across global equities. Again using the example of the S&P 500, implied vol. in the intermediate to longer dated expiries has been pulled much flatter which is a new trend. In the second chart below, the black line is the current term structure set-up, and the 3 and 6-mth change in expectations has been drastic in a month’s time.
• The third table is an all-encompassing look at the change in the realized and implied relationship. The takeaway is that realized vol is trading in the low single digit percentiles in many of the tickers and implied volatility has been pulled lower to match those near all-time lows. A good place to look is at the right side of the table at all of the red z-scores. Implied vol is trading at relative discounts despite the extremes in realized volatility. Again sticking with the S&P example, 30D realized vol of 6.3% is in the 2^nd percentile of historic observations, but 30D implied vol trades at a +28% premium to realized at 8.1%. This may seem like the market remains on the wrong side of trending conditions but some important historical context must be considered:     
  • Over the last two cycles, the low in 30D implied vol. was 7.98% in July 2014, and 8.58% in Nov. 2006. We’re now at 8.1% (likely higher by EOD with this morning's move).
  • Jul 2014: The 7.98% in 2014 was on top of 30D realized vol of 5.81% so that’s a 37% premium which is above today.
  • Nov 2006: The 8.58% in Nov. 2006 was on top of 30D realized vol of 6.84%, so that’s still a 25% premium at the lows in implied vol.
  • Now: The 8.10% currently is on top of 6.3% realized vol for a premium of 28.4%

All-in-all the takeaway is that the broader market is near all-time lows in expected volatility on a go-forward basis which is meaningful no matter what your directional market bias.  

Some historical context around trading ranges...

• Equity indices and related ETFs from Europe, to the U.S. to Asia have traded in historically tight trading ranges in the recent past.
• The table below screens for the extremes in realized vol. The top bucket combines multi-duration volatility (30D60D/3Mth/6Mth) and the second bucket just screens for 30D vol. The DOW, Nasdaq, CAC 40, and the KOSPI all trade in literally the 1^st percentile of historical observations on a 30D window. Energy (XLE) isn’t far behind.      

Skew a clear cut signal of shifting expectations…

One of the most obvious indications of more positive expectations can be seen in volatility skew. Not surprisingly the most positive shifts in skew are in equity markets, mostly U.S.:

• The chart below pulls the extreme in Skew levels for populating the table. 6 of the top 10 least skewed surfaces (TTM Z-scores) are in U.S. equity markets (Russell 2000 ETF is #2 globally)
• When we say “least skewed,” We are comparing the implied volatility on a 90% strike put (Last price *.90) to the implied volatility on a 110% call (last price * 1.1)
• The simple takeaway is that downside puts have gotten much less expensive relative to upside calls
• In energy (USO, XLE, XOP) there is a bit of a divergence in signaling. Skew still remains relatively extended (puts expensive relative to calls), but the implied vs. realized relationship shows a market that is very positive on energy realted indices/ETFs. Energy is still the sector with big discounts to realized volatility on an outgoing basis but the call-out here is that the volatile periods of summer and fall 2016 are being dropped. For example 30D realized vol is trading in the 1st percentile in XLE. 60D vol is in the 24th percentile and 60D implied trades at a -16% discount to realized. XOP 60D implied trades at a -25% discount to realized.

Short-Interest & CFTC Net Futures & Options Positioning:

Net long positioning in the S&P 500 remains subdued given the move in the index the last couple of months, but a swift cutting of total market short-interest paints a different picture on sentiment.

• Russell 2000 Index + E-Mini contract positioning at +1.8x and +2.6x on a TTM and 3-Yr Z-Score basis is among the most extended in the CFTC’s commitment of traders report, but the S&P 500 net long positioning remains near the longer term averages
• Net long positioning in crude oil reached a fresh new all-time high this week. It ranks #1 globally with the most bullish net futures & options positioning
• U.S. equity market short-interest has been cut to a level not seen since January of 2014 as a % Float
• Short-Interest was cut m/m in every sector ex. Healthcare and Telecom where it was flat.

Again, let us know if we can explain anything in more detail. We’re happy to reach out to provide more color as we continue to refine the communication process.