By Tanvir Sandhu
(Bloomberg) --Volatility is back, for now.
The blowup in short-volatility related VIX exchange-traded products is a lesson that what matters is the payoff, not forecasting. Ignoring negative convexity, the tendency for volatility to outpace the relative decline in equities, can be destructive.
Panic selling can cause investors to miss out on significant upside moves. The majority of equity market corrections of 10 percent recover without developing into bear markets. A bear market would mean the S&P 500 falls below 2300, which history suggests is unlikely without a recession. The probability of a U.S. recession currently remains low, given solid synchronized global growth, robust EPS and loose financial conditions. However, this regime won’t last forever.
The decline in equity indices also coincided with the blackout period for share repurchases, which are prohibited by firms in the weeks prior to earnings announcements. This also likely intensified the moves, given corporations represent the largest single source of demand for U.S. stocks. The resumption of solid corporate buybacks in the coming weeks will be a key factor to determine whether this selloff turns into a bear market.
- Once the dust settles, the focus is typically on cyclical sectors vs defensives and small-cap stocks (Russell 2000 Index). Rising interest rates benefit cyclical sectors (e.g. financials) while risks of accelerating wage growth benefits low vs high labor-cost baskets
- Typical late-cycle behavior, particularly with increased sensitivity of the economy to rates compared to previous cycles, sees the trough in volatility this year
- Although short gamma exposure in the VIX market has been largely reduced, vol may settle into a slightly higher range (VIX < 20, the long-term average, > 9, the short-vol bubble) given the need for increased vol insurance, and as QE unwinds
NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice