It’s probably not a coincidence that in the same week in which one of the most level-headed investors of all, Oaktree’s Howard Marks issued an alarm on the current state of the market, that JPM has come out with not one (as discussed previously, Marko Kolanovic’s latest “tipping point” note last Thursday was blamed for the small and sharp selloff at the end of last week), but two reports in which JPMorgan makes it clear that not only is the market on the edge, but increasingly more traders, both institutional and equity, are getting ready for what comes next.
First, as another reminder, these are the 4 bullet points with which Marks summarized the current investing environment:
- The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.
- In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.
- Asset prices are high across the board. Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.
- Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.
One day later, Kolanovic added fuel to the fire, warning that with volatility at record lows, the upcoming mean-reversion will leave many in ruin, and that while there is still time to get out of the market, “we may be very close to the turning point”:
“In what is akin to the law of ‘communicating vessels,’ once inflows in bonds stop, funds are likely to start leaving other risky assets as well, including equities. The FOMC statement yesterday alleviated immediate fears – normalization of balance sheet will start ‘relatively soon,’ but only if ‘the economy evolves broadly as anticipated.’ This reasonably dovish stance pushes this market risk out for a few weeks (the next ECB meeting is Sep 7th, Fed Sep 20th, BoJ Sep 21st). This gives volatility sellers and other levered investors a limited window to position for a seasonal pickup in volatility and central bank catalysts in September.”
Not one to mince his words, the JPM head quant then compared the current period to the period just before 1987’s Black Monday, warning that “strategies that boost leverage when volatility declines, such as option hedging, CTAs and risk-parity, share similar features with the dynamic ‘portfolio insurance’ of 1987,” which “creates a ‘stop-loss order’ that gets larger in size and closer to the current market price as volatility gets lower.” Finally, from a timing standpoint, he said that as growth in short-vol strategies suppresses both implied and realized volatility, and with volatility at all-time lows “we may be very close to the turning point.”
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Over the weekend, in yet another note from JPM, this time from the bank’s “flow” expert, Nikolaos Panigirtzoglou, he writes that none of the above should come as a surprise and that as a result, investors – both institutional and retail – have started putting hedges against an equity crash.
Among the market feature he highlights is that the current put to call open interest ratio for S&P500 index options has been rising for most of this year, and that while this ratio had peaked in June and its current level is not extremely high, it nevertheless stands above its post 2014 average. What is more extreme, is the call to put open interest ratio for VIX options, which at almost 4.0, is close to historical highs.
To Nikolaos, the combination of these two observations implies that “there is greater demand for hedging against equity tail risk or a volatility spike relative to hedging against a typical equity market correction.”
In other words, there is just the right amount of hedging for a crash. And it’s not only institutional investors who are hedging. Retail investors have been also hedging.
Here are the details from Panagirtzoglou’s latest letter:
Our client conversations over the past few weeks have been dominated by the impending reduction of quantitative stimulus by the ECB and the Fed as the main risk markets are facing into the autumn. Our sense from these client conversations is that, as we approach September, the perceived likely timing of balance sheet shrinkage by the Fed and/or ECB tapering, investors have already started reducing their net exposure to risky markets via hedges in order to protect themselves against a repeat of the August 2015 correction. How consistent is this anecdotal evidence with our flow and position indicators?
One way of gauging institutional investors’ demand for hedges is by looking at the put to call open interest ratio for S&P500 index options, the biggest and most liquid listed index option market in the world. This put to call open interest ratio is shown in Figure 1. The ratio has been rising for most of this year. Although the ratio peaked in June and has declined somewhat since then, its current level remains above historical averages pointing to decent demand for hedging equity exposure. In fact, Figure 1 shows that since the oil price shock of 2014 the ratio has averaged at a higher level relative to previous years, i.e. there has been structurally higher demand for hedging equity exposure since 2014 relative to previous years. The current put to call open interest ratio for S&P500 index options is not extremely high, but it stands still above the post 2014 historical average.
Another way of gauging institutional investors’ demand for hedges is by looking at the call to put open interest ratio of VIX options. The use of VIX options has risen exponentially since the Lehman crisis by investors seeking to hedge equity tail risk, credit exposure or volatility exposure. Several investor types such as vol targeting (equity or multi asset) funds or risk parity funds are structurally short volatility and we note VIX calls provide the most direct and liquid way to hedge their short volatility exposure.
This call to put open interest ratio for VIX options is shown in Figure 2. This ratio has been also rising for most of this year, especially over the past three months, as the collapse in equity index volatility to record low levels naturally induces demand for protection against a volatility spike. Typically, the open interest for VIX calls increases in low volatility periods as investors enter hedges, and declines after VIX spikes as investors unwind hedges. Similarly, the open interest for VIX puts increases in periods of high equity volatility as investors buy puts to sell equity volatility.
The main difference between Figure 2 and Figure 1 is that the call to put open interest ratio for VIX options stands at close to record high levels currently, while the put to call open interest ratio for S&P500 index options stands at just above its average since 2014. In other words, there is more extremity in the former implying greater demand for hedging against equity tail risk or a volatility spike relative to hedging against a typical equity market correction.
What about retail investors? Are they also boosting their hedges? We argued last week that the heavy buying of bond funds this year reflects, at least partly, the desire by retail investors to offset or hedge the rising AUM of their equity fund holdings. If this interpretation is correct then this year’s very strong bond fund buying is a reflection of strong demand for hedging by retail investors.
But retail investors are not only confined to buying bond funds for hedging. They also buy VIX ETFs, a universe which has also grown exponentially since the Lehman crisis along with VIX options. Retail investors continued to buy VIX ETFs this year albeit at a slower pace than last year. But their vol buying accelerated over the past month as the VIX index declined to record low levels. This is shown in Figure 3 which shows the cumulative flow into VIX ETFs vs. the flow into Inverse VIX ETFs.
And in Figure 4 which is provided by our Equity Derivatives Strategy team and which uses a more sophisticated calculation to estimate the net vega, i.e. sensitivity to each percentage point change in vol,
Rising VIX ETF exposures are likely reflective of skepticism by retail investors, who are the main users of VIX ETFs, and who see the current combination of record low equity market volatility and record high equity prices as rather unsustainable. Effectively, the collapse in both realized and implied volatility over the past months and the current record low level of the spot VIX index is inducing retail investors to buy VIX products on the expectation that volatility will increase. After all, uncertainty is high and the risk from central bank policy normalization seems significant. So establishing a long VIX exposure via ETFs at current levels appears on surface attractive as it implies a large potential upside, in the case that a negative shock, such as tapering or central bank balance sheet reduction, pushes the VIX up to much higher levels.
But this protection comes at a cost: as more money flows into long VIX ETFs, the VIX futures curve steepens making the negative roll more onerous and the cost of holding a VIX ETF for long rather prohibitive. As a result of the steepness in the VIX futures curve, popular VIX ETFs are currently losing close to 10% per month due to negative roll. If no negative shocks materialize over the coming months, it is likely that negative-carry long-VIX positions are taken off, exerting downward pressure on the steepness of the VIX curve, from currently elevated levels.