Trending Volatility Breakout

“I was in an industrial lab because academia found me unsuitable.”
-Benoit Mandelbrot 

It’s one thing for volatility to cluster, episodically, then fade. It’s entirely another for a breakout in volatility to start to trend. We define @Hedgeye TRENDs as 3 months or more in terms of duration. 

Back to the Global Macro Grind… 

As you can see in today’s Chart of The Day below from our full-time Volatility Analyst, Ben Ryan, what we have currently in Global Macro markets is a Trending Breakout In Volatility. 

For many US centric equity investors this is new. If you invest globally, far from it. 

As you can see in the table of volatility data: 

1. The move in Short-term Volatility (VSTN) for the SP500 just ripped +22.5% in the last week… whereas
2. The 3-month ramp in Global Equity, ex-KOSPI, has been broad-based 

As you move down the table you’ll obviously make your own observations but some obvious ones are: 

1. Oil’s divergence vs. both its asset class (Commodities) and global equities
2. The recent compression in the Euro’s volatility as it and the USD have traded in a tight range
3. A big time compression in Fixed Income volatility on both an absolute and relative basis to Equity Vol 

What does it all mean. Measuring and mapping the “vol of vol” (the volatility of volatility) across multiple durations and multiple asset classes is what we do. It’s part of our data driven process. 

Why? 

1. Money flows chase asset classes with falling volatility (on a trending basis)
2. Money flows loathe and leave asset classes with rising volatility (on a trending basis) 

What are two of the most important economic factors that are causal to breakouts or breakdowns in volatility? 

1. The trending rate of change in INFLATION
2. The trending rate of change in GROWTH 

Do you need an academic white paper on that or can you just back-test it yourself? I don’t think academia would find our findings unsuitable. Going back to school to prove what I already know would make me far less money though. 

Within our broadening research realm of volatility observations, if you’re using the same data dashboards I’m looking at from the same multi-factor, multi-duration rate of change lens every morning, you’ll also note: 

1. That there’s a big absolute and relative divergence in implied volatility premiums/discounts at the US Sector level … and
2. There’s a big divergence between implied volatility premiums/discounts at the Country Equity Index level 

What does that mean? 

1. The SP500’s implied volatility PREMIUM (vs. 30-day realized volatility) has gone from +10% to +43% in the last week
2. Tech’s (XLK) implied volatility PREMIUM (vs. 30-day realized) has gone from +4% to +69% in the last week
3. REITS (VNQ) implied volatility DISCOUNT (vs. 30-day realized) has gone from -7% to -1% in the last week
4. China’s (FXI) implied volatility DISCOUNT (vs. 30-day realized) has gone from -18% to -4% in the last week
5. Emerging Markets (EEM) implied volatility DISCOUNT (vs. 30-day realized) has gone from -9% to -2% in the last week 

Still trying to figure out what that means? 

1. Falling implied volatility DISCOUNTS are usually signs of rising complacency
2. Rising implied volatility PREMIUMS are usually a signs of rising fear and/or hedging (delta hedging) 

Maybe I should go back to school and prove this part out for you but probably not. The proof is already in the empirics as we’re effectively integrating and applying the volatility data into our market timing and asset allocation decisions every day. 

There’s much work to be done. But the most important work is going to be done applying the learnings of the data to market buy/sell decisions and scoring the successes and failures in real-time. 

I guess if someone came into the year bullish on Chinese or Emerging Market stocks, they might be trying to tell themselves that this is “overdone” and the “worst is behind us”… or something like that. 

Both our fundamental research data and quantitative risk management process suggested the opposite. 

“Buying more” of both FXI and EEM either the whole way down in 2018 OR on the recent bounce is pretty much what consensus did. Both of those big macro bets were wrong on both short and intermediate-term durations (FXI and EEM made lower-lows yesterday). 

There should always be lessons learned when making mistakes. 

This one was simple: A) when #GrowthSlowing (Quad 3 or 4) is the research call and B) there’s a trending breakout in the volatility of the asset class… and C) there are deep implied volatility DISCOUNTs developing during the bounce to lower-highs… 

Then you sell the bounce off the immediate-term #oversold signal. 

Our immediate-term Global Macro Risk Ranges (intermediate-term TREND views in brackets) are now: 

UST 10yr Yield 2.83-2.96% (neutral)
SPX 2 (bullish)
NASDAQ 7 (bullish)
REITS (VNQ) 82.55-84.61 (bullish)
Shanghai Composite 2 (bearish)
DAX 110 (bearish)
VIX 11.78-15.41 (bullish)
USD 94.30-95.75 (bullish)
EUR/USD 1.15-1.17 (bearish)
Oil (WTI) 66.71-70.75 (neutral)
Gold 1186-1218 (bearish)
Copper 2.56-2.75 (bearish) 

Best of luck out there today,

KM 

Keith R. McCullough
Chief Executive Officer