The inevitable first step out of the basement in volatility and forward volatility expectations was inevitable and has gained some consensus momentum in April. The VIX reached a post-election high last week and implied volatility has popped in European equities ahead of the French elections. The quick repricing of risk has been driven by expectations and event risk over market moves. Today was the first 1% correction in the EuroStoxx 50 since the beginning of February. We took the small correction to start April as an opportunity to increase exposure again to our favorite domestic sectors as outlined in our Q2 2017 Macro Themes presentation two weeks ago. We reiterated our views in yesterday’s Early Look to start the week: … “The Nasdaq (which I’d buy more of this morning) has corrected -1.8% from its all-time high.” This view on sectors hasn't changed.
Below we draw important conclusions from our daily monitoring of key pricing and sentiment variables, much of it derivatives-markets based. We publish key conclusions ~monthly in cohesion with shifting conditions. Please reach out with any questions.
Here are the key takeaways and call-outs to digest in bullet point form - the focus is mainly on equities in this month's update. We dive into each topic more extensively below:
- Russell 2000 Growth (IWO) vs. Value (IWN) – The Russell 2000 Growth ETF is outperforming the Value ETF by nearly 6% YTD, and a great way to observe market sentiment toward this outperformance is to look at the widening spread between IWN and IWO volatility expectations, which is, as of today, unprecedented.
- Realized Volatility – Among other indicators the VIX reached a post-election high last week, so where has volatility shown up in markets? In Europe? Far from it actually as we discuss below. The biggest positive deltas in realized volatility recently have come in domestic technology – a small correction doesn't change our view here.
- Implied Volatility Premiums (European Equities and Tech) – Implied volatility premiums (implied vs. realized volatility) have exploded in U.S. and European equity markets to fresh YTD highs moving into this week. Our process for looking at premiums is an important discussion to have right now because realized volatility is backward-looking in nature, its moving off all-time lows, and there is elusive political risk in the near future. This factor is a key metric for us that gets oversimplified in the communication process. Contextualizing an implied volatility premium requires a process. There are no magic levels that signal “buy” and “sell” without considering various other factors – more on that below.
- Term Structures Tightening Up of Late – The recent, quick repricing of implied volatility in U.S. equity in April has flattened out term structures in the U.S. (near-term risk). In Europe this shift has happened over the course of the last two months.
- Updated Short-Interest – U.S. equity market short-interest moved higher again month-over-month. Short-interest as a % of float increased in 6 of 11 sectors and was unchanged in the other five. Short-interest bottomed to close out 2016 and consistently moved higher in Q1.
- CFTC Net Futures & Options Positioning – The biggest shifts in contract positioning over the last several months have played out as follows: Crowded treasury contract related short-positioning has been washed out, what was bullishness in the Russell 2000 has reversed, Euro Net Short positioning has been cut to a level not seen since May of 2014, and British Pound net short positioning has been cut to an all-time low (these positions now being tested today).
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Russell 2000 Growth (IWO) over Value (IWN)
The Russell 2000 Growth ETF is outperforming the value ETF by nearly 6% YTD, and a great way to observe the market's view toward IWO from here is to look at the widening spread between IWN and IWO volatility expectations, which is, as of today, unprecedented.
The real-time spread in put implied volatility between the Russell 2000 Value ETF and the Russell 2000 Growth ETF is nearly 9 percentage points wide, which is the widest ever. The second chart below shows this divergence by looking at a two-week average in this spread to smooth the series. The average shows a 4 percentage point spread between IWN and IWO over the last two weeks. For context, Russell 2000 Growth implied volatility has traded two percentage points above Russell 2000 Value implied volatility on average over the last 5 years.
Another way to look at investor angst over IWN is to look at put skew which compares implied volatility on the At-the-Money strike relative to downside puts (80 and 90% strikes). On a standard deviation metric (Z-Score), the Russell Value ETF has the steepest put skew in macro – this is the third chart below.
Realized Volatility
The VIX and VSTOXX (Euro Stoxx 50 Volatility Index) reached a post-election high last week, so where has volatility shown up in markets? In Europe? Far from it until today. The biggest positive deltas in realized volatility recently have come in domestic tech indices and ETFs.
It’s the QQQs and Nasdaq 100 index that have experienced the biggest step-up in realized volatility over the last month. XLK also screens in in the top 10 in macro. See the first chart below.
With all of the political newsiness in Europe and the event-risk reflected in options markets, three of the major European equity indices screen with the largest declines in realized volatility m/m. This has happened as implied volatility has expanded +60-100% m/m in those same indices.
Surprisingly, 30D Realized volatility in the CAC 40 index was at new all-time low moving into today. On a percentile basis, it ranks lowest globally as seen in the 2nd chart below.
The current implied volatility premiums are wide for good reason into the elections this weekend. Implied volatility in the major indices is at a significantly lower level than it was into Brexit. For example EuroStoxx 50 implied volatility on a 30-day contract is trading near 20. Into Brexit, the same contract had a 30 volatility assumption embedded in the price (at-the-money puts). Hedging an equal $ amount of exposure in Europe is less expensive this time around, but the relative change between the current volatility environment, and that implied by prices is much greater. We’re of the view to stand aside and digest the news as it comes. The one thing we would note is that the implied volatility premiums in European equities have screened as the most extended globally for more than two months, based on contracts that expired before this specific event. With the 2017 calendar of political catalyts, hedging of event risk should remain a pervasive set-up.
Implied Volatility Premiums (European Equities and Tech) –
Implied volatility premiums (implied vs. realized volatility) have expanded in U.S. and European equity markets to fresh YTD highs (giving back some of it the last two days). Our process for looking at premiums is an important discussion to have right now because realized volatility is backward-looking in nature. It’s an important factor for us that can be misconstrued and oversimplified in the communication process.
Implied volatility gives insight into what the market thinks about risk in real-time, and the premium factor gives us insight into how that thinking stacks up relative to the market’s trend (change in price and realized volatility). We’re not suggesting that because the top five weights in the QQQs make up 40% of the ETF, that implied volatility won’t have an earnings event hedging premium on top of it (same story with European elections).
However, we can weigh the daily shifting in expectations next to our own views – A pullback in the Nasdaq coincides with a repricing in implied volatility – there’s no mean reversion in options markets that coincide with a short-term move move. Yesterday’s gain in the Nasdaq for example, the largest in a month and a half, happened after implied volatility spiked.
To hash out the premium debate, in our update last month we outlined using straddles to take some chips off the table in the QQQs at the all-time lows in implied and realized vol – premiums always exist in a low vol environment. Our point into this week was that a 60D premium of 65% at the all-time lows in realized and implied vol is a lot different than a triple digit premium, after a pullback from all-time highs, and after realized vol picks up. In other words, implied vol tracks beta in the short-run. We show this sustained premium expansion in the charts below.
Term Structures Tightening Up of Late
The recent, quick repricing of implied volatility in April has flattened out term structures in the U.S. and Europe.
The CAC 40 term structure is now in backwardation and in something like the Nasdaq, it’s nearly flat for the next three months and steepens thereafter. This set-up shows near-term hedging over long-term positions. In the Nasdaq 100 for example, Longer dated implied volatility hasn't budged much. Recall that BREXIT was a volatile event but implied volatility peaked coincidentally with BREXIT, before hedges were quickly unwound in the ensuing weeks. Implied volatility on 30D contracts in the Euro Stoxx 50 was cut in half a month after BREXIT.
The first two charts show how the term structure in the CAC40 and Nasdaq 100 Index has shifted over time. The third chart compares implied volatility on a 12-Mth expiry against front month implied volatility for the SPY and QQQs. Again this flattening in term structure has been driven by short-duration implied volatility rising.
Updated Short-Interest
U.S. equity market short-interest moved higher again month-over-month on the whole. Short-interest as a % of float increased in 6 of 11 sectors and was unchanged in the other 5.
The 3 vs. 6-month trend in the table below is a good summary of what’s happened both recently and in the last year. Short-interest peaked in Q1 of last year coincidentally with the market volatility and was cut in a straight line for the next 9 months through the end of 2016. In 2017, short-interest has started trending higher again. Short interest as a % of TSO has increased the most in Telecom and Energy over the last 3 months. Financials is the only sector where short-interest declined in Q1 of 2017.
CFTC Net Futures & Options Positioning
The biggest shifts in contract positioning over the last several months have played out as follows: crowded treasury contract related short-positioning has been washed out, what was bullishness in the Russell 2000 has reversed, Euro net short positioning has been cut to a level not seen since May of 2014, and British Pound net short positioning has been cut to an all-time low (these positions are now being tested today).
We pulled the first chart below from our Q2 2017 macro themes presentation. The second of our three quarterly themes is reflation’s rollover, and the cutting of treasury and Euro short-positioning should provide some room for this theme to play out as the rates rising mafia shrunk in Q1.
Net futures and options positioning in the Euro hasn’t been positive in three years. Despite a small pullback week-over-week, Euro-related short positioning screens as extended if only because it was a consensus short for three years.
Let us know if we can add color to anything discussed above.
Ben Ryan
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