Last week, we experienced a serious spike in volatility, but a lot occurred under the surface to suggest that we experienced a healthy sell-off and rotation from Tech. The VIX spiked to the $16 handle, and markets dropped significantly, but small-cap relative outperformance sends a strong message.
There are reasons to suspect that last week's volatility could be short-lived since we are entering earnings season. While single stock volatility rises, the index's volatility usually decreases as pairwise correlation falls. The front end of the curve rose, but it maintained its general shape.
Why would I say the sell-off last week was orderly? Well, despite the large size of the sell-off, the VIX curve remained in contango. The VIX shifting to backwardation is a sign of panic and investors fleeing for the exit at all costs.
That didn't exactly happen last week. As you can see, the spot price did get above August and September. Still, the general shape of the curve remains intact and normal, aside from elevated volatility before the election. In true panics, the curve goes completely backward, as shown below, which shows the VIX curve in the depths of the global financial crisis.
These two terms, backwardation, and contango, may seem super complicated, but they should be relatively easy to understand when explained qualitatively instead of graphically:
Contango: This is the more common state of the curve when more time results in more premium since more risks can ostensibly occur the more time passes. When the curve is in contango, it reflects the market's basic belief that more risks are likely to occur as time passes, which makes intuitive sense. So, in a normal state, one month should be less than 3 months, which should be less than six months.
Backwardation: In rare crisis circumstances, when investors are panicking about a short-term or unexpected catalyst, this relationship can be reversed, as in the graph above. This peculiar situation means that the market expects more risks in the short than long term. For example, it becomes more expensive to hedge against one month of risk than against four months of risk. These uncommon situations are typically reversed in relatively short order, as shown below.
So, despite some vicious market price action that brought down index levels significantly, several indications suggest that this was an orderly sell-off rather than the beginning of a new bear market. The fact that the VIX remains in contango is positive. It is a particularly powerful fact when paired with the relative outperformance of the Russell 2000 last week.
Since this index comprises smaller and more vulnerable companies than those that comprise the Dow, Nasdaq, and S&P 500, it can be considered an economic canary in the coal mine. And the signals it is sending are overwhelmingly positive. Weekly periods of outperformance similar to what we just had tend to result in periods of outperfromance for both the VIX and the Russell.
The fact that the VIX stayed in contango and the Russell is continuing to show strength gives me great confidence that we will not see a major inversion before the fear index moves lower. Volatility has been relatively suppressed in this post-COVID cycle, and while some offer varying reasons for this, I think a lot of it has to do with market structure. Overall, my theory on VIX suppression and a flattening of skew seems to be validated by recent market action.
This rally has been marked by investors being more willing to buy call options than put options on the index, which has resulted in subdued VIX levels. Even with last week's volatility, we didn't break the recent 353-day streak of not having a drop of more than 2%.
When people try to theorize about why the VIX is broken, remember that the VIX tends to reflect higher volatility than realized volatility. This says to me that the theoretical mean (which we should be trading toward) is a lot lower than the current levels as of Friday afternoon.
But more than this cryptic fact, low volatility reflects several fundamental market developments. Firstly, COVID-19 was the greatest economic catastrophe of our time, and the businesses, particularly the smaller ones, that survived are hardy and sturdy after facing things like wholesale loss of demand.
On the market structure side, many people forget that many problems were fixed after the financial crisis through the Dodd-Frank Act, making the financial system a lot safer and less prone to panic and opacity. Furthermore, the market circuit breakers proved their meddle in the dog days of COVID, and these mechanisms prevent the exact kind of cascading sell-off that causes VIX prices to spike the most.
When people ask why volatility is suppressed, like there is some sort of cryptic, unknowable reason behind it, I just smile because I know better. And now you do, too. We will use it to our advantage with some exciting upcoming trades. Stay tuned.
