Volatility Disconnect

Posted by: Michael Williams on Wednesday, April 5, 2017
Tags: VIX

While seemingly entertaining, the ridiculous circus that continues to plague the mainstream media chasing tweets and finding any excuse to bash Trump, is doing no one any good. What is worse is that citizens that want and should be informed are unable to ascertain any real news as this Trump vs. Media battle ensues. Unfortunately, even CNBC has taken the bait and you can’t read an article without a jab at Trump. What we need, regardless if you are for or against Trump, is objective journalism because at the end of the day readers, especially in the financial markets, need DATA and hard FACTS to determine how to invest their money. No doubt the markets react in knee jerk fashion to a tweet, but unless that tweet is backed with action, then all we are really seeing is a short-term injection of volatility. Which can certainly give a long-only holder a heart attack, while it is certainly beneficial for the volatility trader. I have all but stopped watching, reading, and listening to purported mainstream media and U.S. news sources, as it takes too much time to sift through the heavily opinionated ideological rhetoric to find a morsel of facts, data, and real news. At least the Economist seems to remain above the fray.


 

Strong Rally

The market has rallied strongly on the Trump election, mostly on assumptions that his economic plan will be great for economic growth. No doubt lower taxes, fewer and more transparent regulations, lower cost healthcare and better trade deals will inject economic growth and increase jobs. That’s basic Econ 101 and basic math. The problem is that none of his policies have been enacted and it seems that the Democrats and even some Republicans will oppose any policy, simply because it’s a Trump policy regardless if it is a good for the American people or not. Politics is ugly and right now it is only fueling hate and not solving problems. So one can’t help but ask themselves if the market rally has gotten ahead of itself and perhaps it is already pricing in some of the proposed Trump economic policies.


 

Volatility Disconnect

What I am seeing is a significant disconnect between the implied volatility, for example the VIX, and some of the hyper intra-day volatility we are seeing in some issues as well as the statistical volatility of some underlying. What does these mean in layman’s terms, simple – the market is not pricing in risk or its pricing in very little risk.

One reason is the interesting phenomenon that move is to the up side in the underlying (note volatility doesn’t know direction), volatility declines purely from a function of math. The higher the price with a consistent ATR (average true range), volatility will decline. However, is that giving us a false sense of security?

I think a better gauge of risk in this current environment is the skew curve, (the slope of volatility from the at-the-money to out-of-the-money options). We are seeing a flattening of the skew-curve to the upside, while the down side continues to steepen. Its seems that the market is becoming more skeptical of the rally when measured by the skew curve when compared to the average implied volatility or even the VIX. Sure the volatility might reflect a more complacent market place when it comes to risk, but looking at the skew curve, it is saying it is not buying into the consistent rally and is starting to concern of a near-term retreat.

Yet, every day we buck this trend. While the mainstream media would have us think, it is the end of the world and Trump is unable to move his agenda forward, the market just jolts higher. The market is ignoring the noise in the mainstream media and continues to believe that Trump’s agenda will move forward. Lower taxes, lower healthcare costs, better trade deals, and fewer regulations is resounding underlying belief that is fueling the rally, regardless if it has happened.

Unfortunately, this belief is facing headwinds. Trump’s healthcare plan didn’t even make it to the floor for a vote, as he was not able to muster enough Republicans to pass the vote. The tax and other issues will face similar hurdles. Certainly, Washington is divided, mostly based on hate fueled politics rather than substance. I don’t like you so I am not going to vote no matter how good the deal is for Americans. Sad days for certain, but I remain optimistic that some positive economic policies will wiggle through. Perhaps I am optimistic because I stopped reading and watching U.S. news.


Two Concerns

While I continue to remain neutral politically speaking, neither a Republican or Democrat, and try to remain objective focusing on the issue – predominantly economic ones, I am concerned.

First, as previously stated in the Market Preview about margin – we are seriously pushing the envelope. How much further we can go and how much more debt financing we can afford is worrisome.

Second, the Federal Reserve Battle Royal that is happening behind closed doors. On one hand I don’t totally buy into Trumps anti-Fed rhetoric. He has bolstered about raising rates and Fed’s wreck less policies – which I agree to some extent, but does he really want them raising rates? I think his battle is an ideological one, not a practical one.  A more hawkish Fed will stall market growth, curtail debt formation, and could usher in a market contraction. Additionally, as Trump is a financer, the cost of money is more expensive and that is certainly something he is not fond of.

Trump will be appointing a couple of governors and I am not sure where Trump stands because I don’t totally believe his Anti-Fed rhetoric. Is he more Keynesian or more Austrian? My belief is that it is circumstantial. In a normal economic environment, devoid of low rates and Fed interventionism, I believe – ideologically – he probably leans more Austrian. Well that is at least, when deciphering his tweets, seems to be his position. However, under the current circumstances, can he afford to be Austrian? I certainly don’t think he can – nor will his business alliances – especially in the banking arena be that keen on a more hawkish / Austrian approach.

Truth be told, even the most ardent Hawks/Austrians in business have become addicted to the Fed’s easy money, low interest, accommodative policy. Who hates cheap money? Just look at the balance sheets and the huge amount of leverage, debt, margin that has been stuffed in there. Seriously, it’s been an 8 year smorgasbord of debt formation of free money and no one really wants it to end, regardless of their economic philosophy.

Seems like the most Hawkish tone I have heard, from all sides of the economic ideological spectrum, has been for steady 25 bps rises every 6 to 12 months. Sounds more Dovish than Hawkish.


Is Trump Stupid?

I don’t think Trump is stupid, regardless of what the media paints him out to be or his tweeting, he has made billions, runs successful businesses, managed to troll the Left (which is easy) to get free media, and became president of the US.  I have tried to judge a person by their action, rather than their words. President Obama was certainly an excellent orator, but judging by some of his actions – well his policies significantly fell short and in some cases, create economic stagnation. Trump on the other hand may be the worse speaking President of all time, but we need to wait to judge him based on action (policies).  Better tax code, better regulations, better trade, better (lower cost) healthcare are all promises.

Regardless of his rhetoric, make those come true and we could be in for strong growth and a booming economy.  I will refrain from the hot-topic social issues, as this newsletter is focusing on the markets and economy, I will leave that heated debate to others.

 


The Dollar

Much like the market, the dollar has been running on perception that Trump will usher in a strong economy based on pro-growth policies. However, like my two previous concerns (margin and rates), the dollar too plays a significant role.

 


If we do get a more hawkish Fed, even if it is just rhetoric and empty promises of rate hikes, it could keep the dollar buoyed against our trading partners and that will continue to impact the trade deficit negatively. The dollar index has come off since January, but remains strong as the expectations of more rate hikes are to come.

Trump is playing an interesting card and that is renegotiating trade deals, which brings a new element to the dollar value forecasting. Previously we valued the dollar and trade, based primarily on competitive central bank interest rate policies. The lowest rates creates the weaker currency and more inflation. However, how will a new trade agreement impact the dollar? That is a huge unknown and I don’t think the brightest minds have any clue. We can make some general hypothesis, but unless we know the potential tax, fines, tariffs or potential incentives with any large trading partner, it is just too hard to determine. What is certain is that it will impact the dollar and certainly the trade deficit.

I believe all the current talk and concern over the dollar value is based on traditional methodologies and not properly weighting in potential trade agreements and their potential impact.

This bring a potential unknown volatility not just to the dollar but to the markets.


Conclusion

I remain firmly in the camp that the VIX along with implied volatilities (in general) is mispricing market risk, in some cases significantly. While I am not predicting a crash, the probability of a market correction is certainly higher than what it is currently priced. The VIX touching single digits is an alarm that we have become far too complacent.

While I appreciate, and respect the Law of Supply and Demand, the margin is at unprecedented levels. One only must look back at 1999 and 2007 to see what happened when margin tapped out. How much more margin is out there, how much more can one borrow to keep inflating asset prices? That is a big unknown question. The two primary factors will be the cost of money (interest rates) and the amount of collateral. I have been reading articles that the millennials are now tapping their home equity like an ATM. Are we always just doomed to repeat history, have we learned nothing?

Stay long, but hedge yourself and don’t be surprised if we see the market faultier in the near term. Perhaps I am overly conservative, but I would rather be prepared and wrong than to ignore risk and hope for the best. Hope is an oxymoron strategy.


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