"Damn the torpedoes. Full speed ahead." -Admiral David Farragut
Last week, the CBOE Volatility Index reminded us of the time-honored lesson that implied volatility moves much faster than price, particularly during periods of elevated uncertainty. Last Monday's VIX spike was one of the largest in history. In terms of the percentage level of the intraday gains, it was the largest ever. But so, too, was the following day when the VIX was crushed and dropped over 30%. Of course, this incredible print on Wall Street's fear index caused fear and gnashing of teeth. Several factors created a favorable environment for a major VIX spike:
Depressed summer liquidity due to so much traveling often leads to normal seasonal weakness.
A jobs report miss that raised recession fears after market consensus had become overly confident of a soft-landing in the economy.
The unwinding of the "carry trade" when the Bank of Japan spooked investors by saying they would force the yen.
The last catalyst was probably the most significant and led to forced liquidations that caused dislocations in other market areas, notably short volatility trades, which have become crowded due to their persistent success over the last year and a half.
I generally think that people tell themselves stories about why markets move that are, at best, only partially correct. There was not one driver of this historic volatility spike but the convergence of several. The good news, though, is that because the market was adjusting to fears of a recession that were certainly higher than they were, the recession still appears to be a minority probability outcome. In other words, if you look below at the conditions where similar VIX levels were priorly achieved, we are in much better straits.
This was one of the most wild market weeks in several respects for many years. The fear index had not spiked so high and sent such an ominous signal since the dog days of COVID, but this particular drop probably had to do more with typical liquidity dynamics that regularly occur on Wall Street in the dog days of summer every year. That's just it, though; the low summer liquidity coupled with a forced liquidation event caused a lot of forced liquidation, which overwhelmed complacent trades that were short volatility.
You can see the timeline of the market events last week. The Monday VIX spike in the futures was definitely precipitous, but it was much more contained than the spot price spike. Overall, the much more relevant development was volatility's subsequent collapse. Most volatility experts agree that Monday's spike was a volatility blow-off rather than the start of a sustained bull market. The spike in the spot VIX price and the futures curve was so pronounced and caused so much market panic that it even prompted famed economist Larry Summers to urge the SEC to investigate.
I issued a trade shortly after the spike last week, telling people it should be shorted. I postulated that the true mean of the $VIX was below $23, and the index settled in the $20 handle on the close Friday. I have had a theory going back well over a year now of why the volatility index has been relatively suppressed in the post-COVID cycle compared to other COVID cycles.
It has some complicated elements, but I want to try to break it down qualitatively because I think it helps explain the more significant development than volatility's spike on Monday and volatility's precipitous and unprecedented collapse over Tuesday through Friday.
Running the Gauntlet of Market Fears
So what seems like a paradox of more risk, lower VIX actually makes perfect sense given the relatively blunt and inconsistent nature of using the VIX as a practical hedge and the added stakes of hedging correctly. The bluntness is only exacerbated by the necessary limitation of upside created by market circuit breakers, which historical observations now suggest are successful in their aim to reduce the exact cascading sell-offs that result in the largest upside for the fear index. -Chris Robb, Increased Market Efficiency, Safer Market Structure Could Subdue VIX
In 1862, the United States was embroiled in a brutal and bloody Civil War. The rebellious South's most important city, New Orleans, was guarded by two massive forts called Fort Jackson and Fort Monroe. In the age of sail, these two obstacles would have been very prohibitive and defended the city. However, Farragut ran the gauntlet at night with steam-powered ships and captured New Orleans, much to the horror of the Confederate South.
I think many market participants wear their bias on their sleeves regarding their antipathy toward regulators. For example, the Federal Reserve recently used emergency powers to solve a banking crisis caused by Silicon Valley Bank's collapse that otherwise might have been unpleasant. It may be easy to forget that we passed the biggest financial overhaul in history in the wake of the financial crisis, and one of its primary focal points is preventing catastrophic forced liquidation that leads to markets seizing up.
Other parts of the regulatory framework, like market circuit breakers, proved their worth during COVID-19. Before their successful implementation, many theorized that these rules could actually cause more volatility, not less, and in a pinch. The proof that they are effective should, all else being equal, limit the kurtosis of the SPX and thus prevent the cascading sell-offs that cause the VIX to spike the most. This explains why volatility stabilized at much lower levels than the Monday spike so quickly.
Overall, I think Monday's massive VIX spike could have front-loaded some of the typical seasonal volatility. Generally, the speed with which implied volatility rose on Monday and then fell indicates that a significant rally is imminent. Yes, some market participants are skittish, but there is also more cash on the sidelines now, and I think the artificial intelligence revolution has only just begun to pay dividends for the powerful companies at its vanguard.
I made two major trades this week: a risk-defined short on the volatility index and a risk-defined long strangle on Nvidia with a bullish bias. The week's events have only made me more confident that these trades will succeed. They are the first examples of the ideas we generated for my new investing service, Punk Rock Traders. The content has been made free this week on LinkedIn and Twitter for your evaluation.
Here is the bottom line: past sell-offs have signaled bear market capitulation, and the VIX curve has tended to stay inverted in their wake as markets processed extremely adverse market conditions. They don't tend to occur in the middle of uptrends, but the fact that this one did occur in the middle of an uptrend is incredibly bullish, in my estimation. It sets up for big price gains to follow the rapid collapse of volatility that occurred Tuesday through Friday. I suspect Nvidia beating earnings will be a major positive catalyst at the end of the month, and I also suspect CPI will validate the market's expectations for Fed cuts next week.
In other words, I think the main upcoming catalysts will have bullish resolutions. Even though recession odds may have slightly risen, the highest probability outcome is still a soft landing that allows stocks to continue rising as the Fed begins its cutting cycle. Recession odds have been coming down, not going up. And I suspect the strong US consumer is still far from buckling.
More than this, though, the rapid change in sentiment toward bearishness simply doesn't match the reality based on my analysis. This is a major opportunity, in my opinion. I believe we are in a strong bull market that just had a healthy correction. Many investors were shaken out of easy trades they were complacent in and will be looking for new areas to deploy funds. Remember that markets climb a wall of worry and fall on a slope of hope, and last week's volatility has made hope in a much shorter supply than it was after Powell's last presser. I am encouraged by the rapid shift to bearishness, as it has marked bottoms in the past.
Trade Update
I am confident in the trades I recommended this week. The November expiration is one factor that favors the VIX contract. There is almost always a post-election volatility crush that I think will play nicely for this contract. My long strangle on Nvidia is very bullish, but I have a lot of confidence in the company. As I wrote in my Federal Reserve piece this week about a restored Fed, put, I believe the next hundred points in markets will be up. You can find all the trade ideas in previous versions of The Black Swan Party.
