Volatility: Low, but downside protection in demand

One of the notable aspects of equity market performance during 2017 has been the rapid fall in market volatility. Trailing 90-day realised volatility for the S&P 500 has reached 7% in recent weeks. Over the last 20 years, these are levels are matched only during a brief period over 2005-2006. We do not see an especially strong parallel with 2005 as at that point US equities were still moderately valued and the US economy was expanding after a mild recession. We believe investors are once again becoming complacent; but also note the skew towards higher priced put options suggesting within the options market at least that downside protection is at a premium.

Exhibit 1: S&P500: 90-day realised volatility

The decline in volatility on an intra-day basis is even more marked with only 6% of recent trading days seeing an intraday range of greater than 100bps. On this measure markets are more placid than at any time since 1997, a remarkable shift from only a year ago when intra-day volatility was exceptionally high, Exhibit 2.

Exhibit 1: S&P500: 3m percentage of days with an intra-day range > 100bps

In fact the CBOE SKEW index, Exhibit 3, which measures the degree of deviation implied by options prices from the theoretical Black-Scholes model, and as such provides a market expectation of downside tail risk, is currently at a record level. While by no means a perfect indicator of medium-term trouble within the equity market, skew was elevated ahead of the original dot-com collapse and the global financial crisis. We believe investors should at least satisfy themselves that they understand why this index is currently at record levels and why downside protection is relatively expensive at present. Technical information on the construction of the index can be found here.

Exhibit 3: CBOE SKEW index at record levels

It is possible the low level of current market volatility is in part be due to an ample pool of natural sellers willing to give up equity upside in return for option premium, given current market valuations. In turn, hedging activity by dealers would act to depress short-term realised volatility. However, if true and should the market gap lower, this technical support for the market would be expected to diminish.

Outside of the technical aspects of the options market, it is understandable that investors as a whole perceive that some of the risks have grown smaller; the populist tide in Europe appears to be in reverse and the economic data from the region has also improved dramatically. Earnings growth forecasts for the US, UK and continental Europe remain close to 10% for 2017 and have been on a rising trend in continental Europe. China did not slow as many anticipated in 2016, even if recent data is equivocal.

However, we would prefer to weight longer-term factors more heavily when constructing portfolios. Portfolios should not be built on the assumption that volatility will remain this low as the historical evidence for mean-reversion is strong. Although many investors may have become habituated, global monetary policy remains very loose and global debt levels remain extraordinarily high.

Equity investors should also recognise there has been a substantial retracement of bond yields during 2017, reflecting ebbing perceptions amongst bond investors for growth and inflation, and as a result global yield curves have flattened.

Just as the short-term improvements in the Eurozone economies have put investors at ease and compressed risk premia in Europe this year, still high levels of debt mean the vulnerabilities remain in the event of a slowdown. Equity valuations, notably in the US, remain extended and this remains true even when the US technology sector is excluded from the calculations.

It would be tempting to view the decline in market volatility as an opportunity to invest in it, perhaps via volatility ETFs. However, investors concerned about the downside need not pay for the upside volatility exposure implicit in many volatility ETFs. In addition, as we have noted downside protection is significantly more expensive than upside exposure. The implied volatility of 25% for out-of-the money puts on the S&P500 does not strike us as a bargain for example. Our preference would be to keep the portfolio strategy simple.

Despite our most recent view that equities are likely to remain supported while profits growth expectations remain intact, we also believe 2017 is a year in which to cover more than one base. We also believe portfolios based on a specific set of bottom-up or event-driven ideas are more likely than usual to outperform index exposure.

Global bond markets have already moved to price in a slowdown and a failure to implement Trump’s fiscal policy agenda; from here gains are likely to be more muted in the short-term and we are neutral on this asset class. However, we continue to see value in niches of the property and credit markets in respect of higher quality assets where yields are still in excess of 4%.

In preference to adding to portfolio complexity with derivatives to hedge risk, we believe investors should first reduce equity exposure and raise cash by taking profits in positions close to target prices and use out of the money put options only judiciously, given current implied volatilities and the drag on portfolio performance due to time value decay.