“In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.”
-Howard Marks in Mastering the Market Cycle
In Chapter 7 of Marks’ new book, The Pendulum of Investor Psychology, he takes readers through some notable moments in his career when broader investment psychology went from “Euphoria to Depression” rather quickly.
Nobody is hanging on what I have to add to that guy’s commentary, but here’s a rhetorical thought anyway:
I have a theory that advancement in ease of transaction and an investor community that is cracked-out on sensory overload creates an environment where the pendulum can swing a lot faster.
Back to the Global Macro Grind…
“Is the market impact of Quad 4 over?”
“Is it time to buy things crushed by Quad 4?”
Those are some of the questions we’ve been asked over the last few weeks.
The answer is still “no” on a broad-scale. Although that “no” looks less convincing than it did toward the end-of-October. That’s the last price reality, but we want to add that a QUAD4 environment in the near future being “less-convincing” is increasingly a consensus view.
Our work to measure and map volatility, positioning, and expectations embedded in derivatives markets serves two purposes:
- Gauging Sentiment: Identify risks and biases embedded in consensus positioning.
- Idea Generation: Find more idiosyncratic ways to play our macro calls (using derivatives to take a directional view).
One of the factors we use to back out forward looking expectations and compare those expectations to the current market environment is with a factor we call the “Implied Volatility Premium.”
*NOTE: An “implied volatility premium/discount” shows where implied volatility trades as a ratio to realized volatility. If 1Mth implied volatility is 15% and 1Mth realized volatility is 10%, the implied volatility PREMIUM is 50%.
We’ll be the first to tell you that the absolute level of this factor should never act as a stand alone transactional signal which many have pointed out:
- “By nature of how it’s calculated you’re comparing a rolling time series to a real-time re-pricing. If a large missile hits a notable landmark, you can throw-out the past volatility environment.”
- “If volatility is extremely high, the existence of an Implied volatility DISCOUNT is not a sign consensus is complacent.”
Our answers to these questions are “yes” we don’t disagree based on how you framed the question.
We care about rate-of-change and fully embrace the fact that volatility is conditional (this premise is key for analyzing the factor’s usefulness but that’s a whole different conversation). It’s an important preface to know that the range of historical outcomes is wider for realized volatility which means:
At volatility extremes, even a day that is uneventful on the margin will push implied volatility toward a “mean-reversion” expectation.
That point is emphasized because it’s exactly what we’ve seen the last two weeks after a very rare environment from a hedging cost and volatility surface perspective. As we show in the Chart of the Day, the U.S. equity market vehicles that:
- Corrected the most in October
- Were most volatile in October (see percentile readings on the far right side of the chart)
- And have bounced the most from the lows
- Have the deepest Implied Volatility DISCOUNTS
Here’s What We Know For Sure about the future vs. past comparison gleaned from the widening implied volatility DISCOUNTS:
A growing “implied volatility DISCOUNT” is rate-of-change proof that the market is increasingly putting October’s volatility environment in the rearview.
To review, if our process here is a mix of 1) Gauging Sentiment and 2) Idea Generation (via derivatives), this morning’s call-out is about Gauging Sentiment (we’re not saying implied volatility has corrected to where “long-vol” via purchasing protection is the best way to play our calls prospectively).
We may not return to October’s volatility environment this quarter, but we know that this conclusion:
- Is increasingly a consensus view extrapolated from derivatives markets
- Isn’t a bet we’d go all in on given the Quad 4 playbook which is born out of a long history studying “growth” & “inflation” environments
- Doesn’t rhyme with our quantitative risk management signals that are pushing us to re-enter on the short-side in many Quad 4 shorts.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
SPX 2 (bearish)
RUT 1 (bearish)
NASDAQ 7005-7606 (bearish)
Utilities (XLU) 52.95-55.36 (bullish)
Consumer Staples (XLP) 54.31-56.99 (bullish)
REITS (VNQ) 77.25-80.98 (bullish)
Industrials (XLI) 67.22-74.42 (bearish)
Shanghai Comp 2 (bearish)
Nikkei 21109-22685 (bearish)
DAX 116 (bearish)
VIX 15.11-26.26 (bullish)
USD 95.60-97.18 (bullish)
Oil (WTI) 59.06-64.67 (bearish)
Gold 1 (bullish)
Copper 2.61-2.79 (bearish)
Good Luck Out There Today,
Ben Ryan
Macro Analyst
