The rebound in the US stock market has caused the fear index VIX to fall to its post pandemic low this month.
Many market participants believe that volatility may remain low for a period of time, which could pave the way for further gains in the stock market. However, some institutions have issued warnings that investors may appear overly complacent. Historically, ultra-low volatility has often been difficult to maintain for a long time, and investors need to guard against short-term adjustments and risk resurgence.
Multiple factors suppress volatility
The Cboe Panic Index (VIX), which measures the volatility of US stocks, hovered around the low level of 12.45 set since 2020 just last week, far below the historical long-term average level of 20. Behind the changes in market sentiment, investors' expectations of the Federal Reserve completing interest rate hikes have driven the rebound of the S&P 500 index, causing it to continuously break new closing highs and achieve its best monthly performance since July 2022 in just November.
Boris Schlossberg, a macro strategist at BK Asset Management, previously stated in an interview with First Financial that "the rise in US stocks was due to loose policy expectations and a decrease in US bond yields. What previously alerted investors was the volatility of long-term bond yields. Now that the interest rate hike cycle is basically confirmed to have ended, the outside world is starting to look forward to interest rate cuts as early as the first half of next year."
Due to the fact that volatility indices are usually opposite to stock trends, they are often seen as indicators of investor sentiment and positioning. Option experts say that due to the dominance of bulls and high risk appetite among investors, volatility for the remaining period of this year may remain low. "There are signs of a collapse in volatility, which may persist until the end of the year," said Ilya Feygin, senior market advisor at institution WallachBeth Capital
As market turbulence subsides, funds targeting volatility have become buyers of the US stock market. These financial products sell when volatility intensifies and buy when volatility subsides. According to data from Nomura Securities, volatility related funds have accumulated net purchases of nearly $30 billion in the week ending November 30th.
Nomura estimates that if the US stock market can maintain a volatility range of around 0.5% within December, these funds may continue to purchase stocks worth approximately $21 billion, providing upward support for the year-end market.
Another factor that suppresses volatility comes from option traders. These traders are now net long "gamma", which means they will sell when the market rebounds and long when the market sells to balance the risk on their books. Brent Kochuba, founder of the options analysis service SpotGamma, said, "The hedging flows associated with this should limit market volatility."
It is worth mentioning that the decline of VIX has made a volatility linked fund a star product in the market this year. Short the VIX index futures ETF (SVIX) by one time as of Tuesday's close, rising 135%, ranking among the top 20 in terms of yield among all US listed ETFs.
The calm before the storm?
Some market observers have seen dangerous signals in a calm market. The data shows that the 30 day implied volatility of the S&P 500 index has dropped below the 30 day actual volatility.
According to research firm Cantor Fitzgerald, after four similar incidents in the past, the S&P 500 index has fallen by an average of 8.5% over the next 31 days. Eric Johnston, head of equity derivatives and cross asset research at Cantor Fitzgerald, said that when implied volatility is lower than actual volatility, it is often a calm before the storm.
Schlossberg told First Financial that the market sentiment seems overly optimistic, and consensus is not a good thing. After a rapid rebound in the short term, he believes that the requirements for driving the market will also become higher, and investors may become more nervous, making it easier to amplify risks, such as the impact of policy and data bearish factors.
Looking back at history, the proportion of VIX in the past five years at or below the current low level is less than 3%. Nomura options market expert Charlie McElliott warns clients that this calmness may not last. "Ultimately, the construction of risk exposure and the recovery of 'bearish' positioning will breed instability again." He believes that there must be a 'brand new catalyst' to initiate risk release.
Nicholas Colas, co-founder of DataTrek Research, wrote in a report, "Simply put, the US options market has completely freed itself from concerns about inflation, aggressive monetary policy by central banks, geopolitical uncertainty, pressure on corporate profits, and higher long-term interest rates." He added that this is indeed the case, "Seasonality is an optimistic factor, but this alone cannot explain the unusually low volatility index. On the contrary, the most troublesome thing is that the market believes they have solved everything."
McElliott mentioned the possibility of triggering unrest. This includes the re acceleration of US economic data, forcing investors to reassess the possibility of interest rate cuts in 2024, or the Bank of Japan ultimately abandoning its ultra loose monetary policy, triggering another round of volatility in the global currency and bond markets, affecting the US stock market.
Overbuying of technical indicators is also a reason for short-term market adjustments. Michael Hartnett, a star analyst on Wall Street and global chief investment strategist at Bank of America, stated in a report that the company's reverse bull bear indicator, which evaluates factors such as hedge fund positioning, stock and bond flows, has exited the "buy" range for the first time since mid October. He wrote about the prospect of further rebound in the future, "If you haven't caught it, there's no need to chase it now."