Mid-week market update: Is the worst of the Japanese risk-off episode over? The Nikkei formed a
bullish harami pattern when it recovered on Tuesday, but the recovery candle formed an “inside day” compared to Monday’s massive downdraft. As well, BOJ deputy governor Governor Shinichi Uchida calmed markets and struck a dovish tone when he said that the Bank would “refrain from hiking interest rates when the markets are unstable”.
While I am hopeful that the worse of the panic is over, I have some nagging doubts. Here’s why.
Insufficient fear
While most historical studies of sudden volatility spikes from an unexpected reversal of crowded positions have resolved in higher stock prices over time horizons of one month or more, I am seeing possible signs of insufficient panic that may resolve in further near-term weakness.
The accompanying chart shows the evolution of the VIX Index (bottom panel) and SKEW (middle panel), which measures the cost of downside tail-risk protection. Even though SKEW has risen, it is only in the middle of its recent historical range. Where’s the fear?
Here is the same chart in 2015 at the time of the surprise Chinese yuan devaluation. The S&P 500 skidded in response to the news and VIX spiked. SKEW was low at the time of the even, and took 2-3 weeks to rise the reflect increased downside protection costs. Stock prices weakened to retest its lows about a month after the initial low.
Here is the
Volmageddon downdraft of 2018, which was caused by excessive crowding into short volatility products. VIX surged. SKEW also rose dramatically afterwards from historically low levels. Even though the S&P 500 pulled back about three weeks later, the sudden and dramatic increase in SKEW may have mitigated some of the downside equity price risk on the pullback, though the market did weaken to test its lows about two months later.
Fast forward to 2024, this hourly chart of the VIX Index and VVIX, which is the volatility of the VIX, shows that while VIX has declined, VVIX remains elevated, indicating residual anxiety in option volatility pricing.
Admittedly, this historical study has a very small sample size (n=2). Other volatility spikes, such as the one in 2008 (GFC) and in 2020 (COVID Crash) were macro driven and had longer lasting effects on the economy, which is not likely in the current circumstances. Nevertheless, the lack of strength in SKEW is worrisome.
Downside catalyst
One source of possible downside volatility is the looming threat of an enlarged Middle East conflict.
News sources report that U.S. intelligence believe that an Iranian attack on Israel could come as early as late this week or the coming weekend.
There was also this report that Egypt had advised its airlines to avoid Iranian airspace overnight Thursday.
While I have no idea of the timing of an Iranian attack against Israel, even the threat of an attack will unsettle markets and trading desks won’t want to be long risk over the weekend. Don’t be surprised if the stock market sees a setback on Thursday and Friday.
In conclusion, how traders position themselves in the wake of the latest volatility storm is a matter of risk and time horizon. It’s likely that stock prices will be higher 1-3 months from now, but how the market gets to those higher prices is an open question. My inner trader continues to hold a long position in small caps. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long TNA
The LTCM drop was very similar, in what we see so far. There was a double bottom.
Both LTCM and this recent Yen carry spat were also in bull markets. The sentiment in a bull is positive, I don’t know if this would account for what you are seeing in the skew.
I would add that should the market recover and make new highs, this will put jet fuel into the euphoria machine.
The VIX is a measure of put option buying when traders buy downside protection. The current environment for vast amounts of hair-trigger, one-sided option trading causes spikes unlike anything we have seen in the past. Maybe we should just ignore it or use a multi-day moving average or ….?
The SKEW might be the only panic indicator worth watching. The short-term options market is just a casino playground with players with no real investment opinion other than gambling on hourly swings. The new one day options are simply rolling the dice without real investment thinking, just minute by minute news feeds.
My part-time young data assistant is telling me about his $500 option spreads and reverse spreads to make a $100 here or there and occasionally more. He is on REDDIT sharing stories. Put a million young people doing this and you have half a billion sloshing around that can tip the boat if they all go to one side.
This is a new world and VIX is no longer the indicator it was.
As far as I can tell, SKEW very often lags considerably, often for many months. For instance, it was at a low in March 2020, and rose to a top in July of 2021, hence I don’t at all know what insight I could have gained from observing it during that time period.
FWIW, Lufthansa has also cancelled all flights to the middle east region.