Thoughts on Market #006 - Volatility Evaporation
Charts and Narratives Explained
Everybody loves Charts!
Every so often, I’ll check in to show some items floating around Wall Street circles and blogs.
Longer term trends in the markets and economy.
Extra details on what seems underappreciated or overhyped.
Link to some great explainers on the concepts.
**Everything as of 7/15/2023
The VIX Tanks
The story of June 2023 was the relentless decline of volatility in the markets. The VIX index finally returned to Pre-COVID levels while indices made a run at returning to all time highs.
The question is Why?
Why is everything in equity market territory reading as complacent in a world with
Interest rates continuing to trend upward
Poor Market Breadth - only U.S. Tech companies leading indices higher
Cash draining out of equity markets & into money markets week after week
Geopolitical tensions showing no signs of abatement.
Best I can tell, there are 3 theories floating about.
Theory 1 — Things Are Getting Better
The above is the Bloomberg ECO US Surprise Index. Any value above zero (orange dotted line) suggests real economic data points, like monthly inflation numbers or weekly employment numbers, are publishing in a more positive direction than median forecast expects them.
You can see it’s shot to the moon in June 2023.
The basic idea behind this theory is — a solid run of published values above median estimates have been reported. This suggests key areas of the economy are in better health than we thought. This adds confidence to portfolio managers’ decision to deploy cash and buy securities.
Portfolio managers generally deploy their cash to buy stocks in a smooth and regularly timed way. This regularity of cash inflow is keeping volatility at bay.
It’s surprisingly hard to find the exact calculation methodology for any proprietary corporate index. If anyone knows where to find white papers or explanations for the exact formula on this —-send it over!
Theory 2 — Everyone is positioning themselves
The above graphs shows estimated Gross Exposure and Net Exposure of CTAs (CTAs are Commodity Trading Advisor firms). The details of this exposure calculation get advanced but essentially several banks publish data on how their CTA clients are submitting orders to them.
Based on the orders they submit and execute on the CTAs behalf, Bank Research Depts can extrapolate how much risk the funds are accruing or shedding from their balance sheets.
The Net exposure value is a measure of a fund's amount-at-risk. Above Zero means more risk (and hopefully more return)
The basic theory is — again, funds are deploying cash to buy up securities and add risk. Regular cash deployments by big funds keep volatility at bay.
Theory 1 is really just the hypothesis behind Theory 2:
In Theory 1, the argument goes —> good economic surprises means I should take on more risk by buying stocks —> Buying up stocks cause low volatility.
In Theory 2, the argument goes —> CTAs are taking on more risk by buying stocks —>Buying up stocks cause low volatility
Theory 1 is the best guess why those CTAs are showing the traits of Theory 2 at the moment
Theory 3 - Seasonality and Mean Reversion Are In Play
The above graph shows the average VIX value each month for 2023 versus the average levels since 1990.
The basic theory suggests the VIX is falling in Q2 because, on average, that’s what it does every year.
The other part of this theory is mean reversion and it accounts for the extreme declines. After a prolonged bout of elevated volatility beginning with COVID, an opposite period of unusual complacence is due to balance the long run average.
In an esoteric way, this is the market finally saying COVID and COVID related actions no longer impact the market. We’re back to where we were beforehand.
Bonus Chart
You see, it’s accurate because a lot of people died in 1912 but recently 5 more people died due to the Titanic in 2023
TRADERDADS MAILBAG
Thoughts? Questions? Comments?
Reach out! Maybe I’ll do a full post on the topic or as a Q&A
traderdads@substack.com
