What Goes up Must Come Down

April 29, 2021

Source: Bloomberg Source: Bloomberg

About one year ago, in one of my previous Chart of the Week posts, I noted the unprecedented high equity volatility witnessed by investors. Today, equity volatility is anything but extraordinary by historical standards. The Chicago Board Options Exchange (CBOE) Volatility Index (VIX), which reflects the expectation of near-term S&P 500 Index volatility, closed at 17.33 on April 23. The average of the index for the last 10 years is 17.63. This week, I would like to share some interesting observations about equity volatility through the pandemic so far.

First, as seen in this week’s chart, equity volatility is receding. This is largely due to the rapid rollout of COVID-19 vaccines and actions taken by both the government and Federal Reserve (Fed). The successful vaccination campaign and the continuously improving infection statistics boost investors’ confidence that the economic recovery will be fast and furious. The Fed and government policies have ensured smooth market functioning and ample liquidity.

Looking back, it took a little while to get where we are now. The VIX had stayed above 20 for 254 consecutive trading days, which is the second longest streak since the inception of the index, trailing only the period after the 2008 financial crisis. The VIX is calculated based on the short-term S&P 500 Index options traded on the CBOE. There are two major factors determining the level of the index. The first is the expectation of near-term S&P 500 Index volatility, while the second is the risk premium derived from the supply-demand dynamic. The latter factor played a significant role in the index remaining elevated for an extended period of time. Even though the index is around its historical average now, investors are not being complacent. The deep out of the money put options representing tail hedges are still quite expensive relative to history.

Additionally, the Nasdaq 100 Index and Russell 2000 Index volatility have larger premiums compared to the S&P 500 Index volatility. Due to the compositions of those two indices, they should have higher volatility than the S&P 500 Index. The Nasdaq 100 Index is concentrated in the technology sector, hence lacking diversification. The Russell 2000 Index includes 2000 small-cap companies, which have weaker balance sheets compared to large-cap companies. But the volatility premiums are larger than usual. For the period from Oct. 1, 2020 to April 23, 2021, the average volatility premiums of the Nasdaq 100 Index and the Russell 2000 Index were 5.8% and 8.0%, respectively, compared to averages for the last 10 years of 2.5% and 4.6%.

The driver behind this divergence has been factor and sector rotation. The majority of the stocks in the Nasdaq 100 Index are considered growth stocks. The Russell 2000 Index includes many value stocks. When the economy is recovering, value stocks tend to outperform growth stocks. But, based on the last decade’s experience, investors view the value trade as a tactical trade. It is very susceptible to any signs of stalled economic recovery. The back-and-forth factor and sector rotation has uplifted the volatility of these two indices.

Lastly, the green-dotted line in the chart represents the volatility of 20-plus-year Treasuries. Given the straightforward relationship between Treasuries and interest rates, it is a decent approximation for interest-rate volatility. Interestingly, this index has surpassed the VIX several times since March, which is unusual historically. It occurred back in 2017 when the VIX was extremely low, but today’s VIX level is average rather than low. A more comparable instance would be the 2013 taper tantrum, when markets started pricing in additional tightening from the Fed, lifting interest-rate volatility. If interest-rate volatility is here to stay, equities would expect a bumpy ride ahead.

Key Takeaway

As the economy is reopening and people are gradually normalizing their lives, equity volatility is abating. The further we get from last year’s volatility storm, the more volatility sellers should get back to work. However, we are still in the middle of a global pandemic and there is no shortage of uncertainties. It is hard to see equity volatility falling much further from here. Looking forward, I would expect equity volatility to be range-bounded, barring any virus mutation that materially weakens the efficacy of vaccines. Given the elevated equity level and cheaper equity options relative to last year, either delta replacement or outright hedge are reasonable. Also, the S&P 500 Index volatility term structure is very steep. Rolling down the curve could be an attractive carry strategy if your risk management allows it.

Tags: equity volatility | COVID-19 pandemic | S&P 500 Index | VIX Index | Nasdaq 100 Index | Russell 2000 Index | Treasuries | Interest rates | Federal Reserve

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