Near-term volatility expectations have plunged to record lows.
Trader sentiment has officially come full circle following the election. On November 1, we observed that “Investors Are (Over?-)Prepared For Election Volatility”. Our evidence was that the 9-Day S&P 500 Volatility Index (VXST) was trading at near-record levels relative to the 1-Month Volatility Index (VIX). At its peak, the VXST/VIX Ratio would hit 1.35. That marked the 2nd highest reading in the VXST’s 3-year history, trailing only August 21, 2015 (when the S&P 500 was essentially crashing). We thought this reading to be quite odd considering the rather pedestrian decline in the market. As they often
do, these traders indeed got the short-term volatility they were looking for (if only overnight on election night). But that volatility vanished as quickly as it arrived.
On November 11, 2 days after the election, we wrote a post titled “Traders Breath Unprecedented Sigh Of Relief Following Election”. The impetus here was the fact that the VXST/VIX ratio, as well as the VIX/VXV (3-Month VIX) ratio, each saw their largest daily drop ever on the November 9 election day. In other words, traders had seen their relative comfort level improve faster than any other date in history.
That was a week ago. Fast forward to today and we see that, not only have volatility expectations vastly improved on a relative basis, they are now testing all-time record lows on an absolute basis. The VXST, specifically, printed an 8-handle (8.98) for just the 2nd time in its history today. Furthermore, the VXST/VIX ratio closed at an all-time low yesterday, moving below 0.7 for the first time ever. That indicates that traders already had low relative volatility expectations for the near-term. And, clearly, their comfort level has come full circle since just prior to the election.
So what’s the point – besides the triviality of the cycle – or the lesson about traders’ inevitable comeuppance once they’ve become too prepared for volatility? Well, looking historically, the combination of an extremely low VXST and an extremely low VXST/VIX ratio has not been kind to the S&P 500, at least in the short-term.
Specifically, after these past 2 days, there have now been 21 days in the past 3 years in which the VXST dropped below 10 while the VXST/VIX ratio was less than 0.835.
To utter those famous last words, this time may be different, but as we mentioned, the S&P 500 demonstrated consistent struggles in the short-term following the previous 19 occurrences.
Some of the dates are clustered during this past August-September. But interestingly, they were mostly singular events, suggesting that these conditions are extreme, and unsustainably so. Therefore, whatever effects tend to occur as a result of such conditions, they tend to happen right away. Naturally, those include a rise in short-term volatility expectations and, as the table indicates, softness in stocks.
A week later, the S&P 500 was higher just 4 of 19 times, and it didn’t get any better after a month with just 3 winners. Even after 3 months, the 16 occurrences with enough data were lower three quarters of the time. The most consistently weak spot was 3 weeks following the readings. 17 of the 19 dates saw lower stock prices by then.
The consistency of the drawdowns (not shown) also jumps out. Within 2 weeks, 14 of the 19 occurrences had seen -1% drawdowns. By 1 month later, 15 of the 19 had experienced drawdowns of at least -2%.
That said, the weakness, while consistent, tended to be rather limited. For example, while 16 of the 19 days saw losses 1 month later, none of them were down even as much as 3% (unrounded). Even the drawdowns saw just 5 of the 19 down by as much as 3% at any point during the first month.
Certainly the limited magnitude of the losses has to do somewhat with the benign, range-bound environment that existed over most of this study period. Therefore, perhaps it’s just coincidence. And perhaps the losses following similar conditions as we are seeing now is just a coincidence. However, 17 losses out of 19 occurrences would suggest otherwise. It suggests that perhaps traders had just gotten a bit too comfortable with the stock market at those junctures, at least in the near-term.
And they have never been as comfortable as they are now.
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The commentary included in this blog is provided for informational purposes only. It does not constitute a recommendation to invest in any specific investment product or service. Proper due diligence should be performed before investing in any investment vehicle. There is a risk of loss involved in all investments.