After a three-year stretch of significantly lower than average volatility in global markets, the volatility spirits rediscovered their mojo in recent weeks. Instead of jumping on a crowded bandwagon and examining and reexamining all of the reasons “why” global markets have entered correction territory, we thought it might be interesting to provide some visuals that show how quickly greed turned to fear in risk markets and show how the fear associated with the recent correction compares to past episodes. As you will see below, and as we’ve pointed out in the past in various venues, though markets have displayed signs of complacency at various points during this uptrend, market participants have been very quick to jump to pessimistic extremes at the first signs of market distress, even though the overall corrections are minor in scope relative to past speed bumps.
Let’s look through some of the charts.
First, let’s look at the truest representation of market volatility, realized volatility in the S&P 500 and MSCI EAFE in recent days and weeks. We accomplish this by taking the 20-day standard deviation of daily market percentage moves. Simply, higher standard deviation numbers mean dispersion or volatility in the daily performance numbers over the trailing 20-day period has increased. We’ve included a chart of 20-day standard deviation that covers 1958 to the present. You’ll see below that in recent months, volatility hovered around the lowest levels ever observed in the data series for both the EAFE and the S&P 500. As bad as recent action has felt, however, the recent turmoil has barely taken actual volatility for the S&P 500 above its long-term average. Interestingly, despite the fact that the MSCI EAFE has corrected far more than the US-specific S&P 500, EAFE realized volatility remains below the historical average. Realized volatility for both indices hasn’t even scratched the surface of the volatility observed during the 2011 European debt crisis. Overall, it’s felt like a wild ride in recent weeks, but only because our collective perceptions have been warped by the extended period of unusually low volatility.
The overall corrections have been contained thus far by historical (or even recent) standards, and realized volatility, as we’ve seen above, hasn’t really come close to touching levels observed during past corrections. How’s psychology holding up? Traders and investors wilted pretty quickly out there. Let’s look at three different gauges that help measure investor psychology: the CBOE put/call ratio, the ISES Sentiment Chart, and the relationship between the VIX and VXX volatility measures.
The CBOE put/call ratio spent the early part of this year near the lowest levels observed over the past decade (higher levels indicate more put activity relative to calls, hence more fear). With the recent correction, the 10-day average for the put/call ratio quickly rebounded to levels nearly 2 standard deviations above the average going back to 1995.
We see a more dramatic story in the ISES indicator, which also measures put activity relative to calls. This indicator operates in reverse; lower levels indicate more fear in the markets. Here, the 10-day average for the indicator has reached levels not observed since the depths of the financial crisis in 2008/2009. As recently as early September, the ISES was approximately 1 standard deviation above the longer-term average. Now, it’s reached levels approximately 2 standard deviations below the norm. By this indicator, overall fear in the market is significantly disproportionate to the actual disruptions taking place in the broader markets and the magnitude of the change in market fear over such a short time frame is dramatic when considered against the overall market backdrop. At this point, it appears that traders have been overemotional.
Next, let’s look at the relationship of the VIX Index to the VXV Index. The VIX measures 30-day implied volatility for at the money S&P 100 index options. The VIX is probably the most widely followed “fear gauge” in the marketplace. The VXV, a cousin of the VIX, measures 90-day implied volatility. During normal periods, the longer term implied volatility as measured by the VXV is lower than shorter term implied volatility as measured by the VIX. During periods of market fear, this relationship is upended with near term-implied volatility spiking past longer-term volatility. We see below that the VIX:VXV relationship reached levels this week that haven’t been observed since the Europe-induced correction of 2011. Despite the fact this correction (to this point) is roughly equal in terms of magnitude to the corrections experienced during the summer of 2013 and early summer 2012, this fear gauge, like the ISES above, is acting as if a much greater calamity has taken place.
Are the recent gyrations the first shots across the bow in advance of much bigger market problems? Granted, just because spikes in fear gauges have outpaced the actual disruptions in the markets doesn’t necessarily mean all is well, the contrarian stabilizers are ready to kick in, and that markets are going to resume their march ever higher. For instance, we can look at the charts above and see that the fear gauges spiked to levels near current levels at the beginning of 2007 and remained at those levels, even though the worst parts of the market calamity and financial crisis didn’t arrive for another year to year and a half. Yes, some of those extreme fear levels triggered some large upward counter-rallies throughout 2007 and 2008, but they turned out to be small drops in the bucket compared to the large downward moves taking place during that time period.
At this point, our work still suggests there’s no reason to believe that the current market correction is ready to morph into anything akin to the problems experienced globally in 2008/2009, or from 2000 to 2002. While leading economic indicators in Europe and Japan are becoming problematic, similar to early/mid 2011, the US and other regions continue to show very little risk of imminent recession. Yes, intermediate to longer-term market technical indicators have broken down again in Europe. The upward story, however, remains intact to this point in the US and Japan. Valuation is above average in the US on a longer-term basis using adjusted CAPE measures, but not at the levels observed in 2007. As such, we believe the worst-case scenario at present is a correction similar to the ones experienced in 2010 and 2011. Those corrections were certainly painful in the short-term but proved to be short-duration setbacks within the larger uptrend. Against that risk scenario, we hold the view that investors have overreacted to this correction in a manner similar to overreactions observed in May-2012, Fall-2011, and spring-2010.
Of course, if the data changes, we reserve the right to change our minds. We’ll be the first to shout from the rooftops if anything in the model changes suggesting that something much more momentous and dangerous is on tap for investors.
