The bull market turned nine years old on Friday and has more than quadrupled since March 2009, making this the second longest epic run on U.S. stocks. Moving forward, the outlook remains optimistic, with contained volatility, even after sliding into correction territory early this year.
What Happened in January?
Betting on volatility, or rather a lack thereof, was a crowded trade in 2017. Considering the big notionals on the line for short volatility traders, closely following macroeconomic conditions, like the state of the US job market or communications from the Fed, is crucial. Sudden shifts in said macro factors can shift expectations of corporate performance. Specifically, and as was the case at the beginning of the year, higher-than-expected U.S. wage growth meant faster-than-anticipated inflation and subsequent premature rate increases. Wage inflation and refinanced debt at higher rates would introduce unaccounted for downward pressure on expected profits, thus eroding market confidence and introducing volatility as a prelude to market corrections to come.
As the short trade began to unwind in January, following slightly surprising new employment data, the less desired side of the trade feedback loop kicked in, with volatility begetting more volatility, sending the VIX to levels only seen after Lehman Brothers failed.
Complacent Much, Wall Street?
It’s important to note that whereas a 2008 soaring VIX reflected legitimate market issues, this instance was just the natural fallout following holding, for long periods, instruments designed for short-term or even intraday hedging with a clearly communicated long-term expected value of zero in their prospectus. A Twitter thread by Charles Forelle, financial editor at the WSJ, provides a brilliant commentary on the matter. Therefore, the presumably sophisticated investors holding these instruments really had it coming. Complacency always has a price, thankfully for them, the bill wasn’t as hefty as it could have been. The traditional relationship between the VIX and the S&P broke down. An article by the WSJ explained that had the S&P fallen in line with its historical pattern, the market would have plunged about 27% in a day, following a more than double growth in the VIX. Instead, it only dropped 4.1% that day.
Time Heals All (Non-Systemic) Wounds
January pay gains that spooked markets were recently revised down to 2.6%. The subdued catalyst is likely to halt any further sell-off in equities and restore positive investment sentiment. More likely than not, the 10% drop in the S&P from its earlier high hit isn’t indicative of deeper troubles ahead. We can find a further evidence of lowering levels of anxiety in the market by looking at the VIX futures curve. In February, the curve was in backwardation, signalling that investors were expecting more uncertainty in the short term. While the VIX futures curve doesn’t currently have the same obvious contango structure as the last time the stock market closed at record highs, it’s shifting to a minute contango. The upward slope provides confirmation of a return to normal trading conditions. Ultimately, the reason the volatility trade unwinding didn’t catastrophically ripple through the markets lies with its holders. Contrary to 2008, most short positions were not in the hands of systemically important banks but rather in those of institutional investors who understand the risk and should have the resources to absorb subsequent shocks.
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