March Lamb, April Lion:
VIX Roars
It’s tough to know whether the volatility spike to start Q2 begins a larger trend or is simply a counter-move in a longer-term bull market. But the risk premium? Still priced in.
Words By
Frederic Ruffy
There’s nothing meek about the way the second quarter kicked off. The S&P 500 moved to multi-year highs on the first trading day in April and then suffered a swift five-day 3.5% skid.
Some of the best performing sectors of the first quarter are now the market’s biggest losers. The CBOE Volatility Index (VIX) was on an eight-day winning streak as of April 10 and recaptured the 20 level for the first time in more than a month. The volatility index tracks the expected volatility priced in to S&P 500 index options and is sometimes called the market’s “fear gauge.” And, as often happens, VIX increases as the market moves down.
Italian and Spanish bond yields probed worry-inducing highs yet again and some key U.S. economic data, including the jobs report, missed the mark in the days leading up to the latest round of earnings releases. While there is no way to be sure, the net result could be a dramatic change in the volatility environment in the weeks ahead.
Out of Gas
Sector action has turned mixed and the strong gains seen during the first quarter have been followed by more volatile action across most sectors of the equity market. The one-month Heat Map from TD Ameritrade’s Trade Architect is beginning to show more red squares than in the previous two months. Technology and financial sectors are still seeing substantial shades of green thanks to solid showings from some of the large cap names (Note that the bigger the square on the Heat Map, the larger the market value of the company that the box represents). Consumer and healthcare sectors are beginning to see mixed action during the past month. The industrials and basic materials groups are also among the weakest. Only two names within the oil and gas industry have posted gains in the past month. The utility group, which was the only losing sector in the first two months of 2012, continued in that direction.
Figure 1: Trade Architect Heat Map shows most sectors dappled with a generous amount of red. Overall, the market’s strong 2012 start slowed visibly in the past month. For illustrative purposes only. Past performance does not guarantee future results.April Fools?
The S&P 500 Index gained 12.2% in the first quarter, according to Thomson Reuters data. The advance was driven by gains across most S&P sectors, but a change of trend might be underway. All nine sectors have suffered losses in the first six days of April. Financials, which paced the advance in the first quarter, are leading the decline with a 4.2% loss. Industrials and Materials were also among the biggest gainers in the first quarter and are now suffering the largest losses. Energy, which lagged the field in the first three months, is now in negative territory for the year.
| SECTOR | Q1 | Q2 TO DATE |
|---|---|---|
| Financials | 21.5% | -4.2% |
| Information Technology | 18.5% | -1.8% |
| Consumer Discretionary | 15.6% | -1.2% |
| Industrials | 10.8% | -2.9% |
| Materials | 10.4% | -2.3% |
| Health Care | 8.4% | -2.7% |
| Consumer Staples | 4.9% | -1.3% |
| Energy | 3.8% | -4.3% |
| Utilities | -2.6% | -2.1% |
| S&P 500 | 12.2% | -2.6% |
FIGURE 2: S&P Sectors Q1 and Q2 performance through 4/13/12.
Source: Thomson Reuters. For illustrative purposes only. Past performance does not guarantee
future results.
Since there have been no winning sectors, the S&P 500 Index is giving back some of the 12.2% gain seen since December amid increasing levels of volatility, according to Thomson Reuters data. It was a slow grind higher for several months and the S&P 500 was recording multi-year highs heading into month of April. The average daily moves in the index in the first three months of the year were just 6.2 points or 0.46%. Fast forward to early days in the second quarter and the average daily moves are now 13 points or 0.9%. By this measure, volatility has doubled.
It's Getting Crowded In Here
After falling to multi-year lows of less than 14 mid-March, VIX has recaptured the 20 level in early April. From March 28 to April 10, VIX recorded an 8-day 31.8% winning streak, according to CBOE data.
FIGURE 3: VPD is an index that tracks the theoretical performance of selling 1-month VIX futures. It has returned to July 2011 highs during a volatile April start. Chart from thinkorswim’s ProphetCharts. For illustrative purposes only. Past performance does not guarantee future results.In the March Volatility Report (see VIX Vs. Mr Market), we discussed the term structure of the VIX and noted that while the index was near 15.5, September forward values for the index were roughly 24 and December at almost 30. The curve for the VIX was very steep and the trend offered solid evidence that expectations regarding future volatility were much higher than the near-term VIX might suggest. Today, the curve has flattened a bit. VIX is near 20, while September and December forward values remain at 24 and 30, respectively. The curve flattening in early April could be a sign of greater hedging activity (put buying) in shorter-term options. Whereas investors had been primarily hedging with longer-dated options on worries about problems in the future, the activity reflects growing concern about what is transpiring in the financial markets right now.
The term structure of VIX options also reflects a popular strategy within the institutional investing community that involves selling short-term VIX futures. For example, the CBOE VIX Premium Strategy Index (VPD) has been on a tear. VPD is an index that tracks the theoretical performance of selling 1-month VIX futures. It plummeted from July to October of last year when short-term volatility was rallying on macroeconomic worries. Since that time, the index has returned to its July highs after gaining nearly 45 percent off early-October lows.
Changes in volatility can happen without a moment’s notice or can take place gradually over a period of time. There is no way to know if the increase in volatility in the first few days of the second quarter is part of a larger trend or simply a counter-move in longer-term bull market. But it is clear that a popular strategy of selling short-term volatility has resulted in steepness in the term structure of VIX. It is a trend seen across most actively traded index products. Short-term volatility is low, but longer-term volatility remains elevated and reflects the risk premium that still exists due to lingering macroeconomic concerns. The potential hidden danger is a change of trend that forces a rethinking of risk perceptions, which could possibly translate into a reshaping of the curve and a sharp rally in levels of short-term volatility.
