Is VIX the next market blunder?

Is VIX the next market blunder?Is VIX the next market blunder?

ETF Securities Equity Research: Is VIX the next market blunder?

Highlights

  • The VIX index is currently demonstrating a complete absence of fear. In the context of current world affairs and political instability, we believe this is demonstrating a worrying complacency amongst investors.
  • Shorting the VIX is a dangerously crowded trade. The risk of market dislocation increases as interest rates rise.
  • The VIX and equity valuations are unusually closely correlated, implying that investors are buying equities due to their low volatility, and are comfortable with high valuations as a result. As we believe the VIX is likely understating risk, this puts equity investors in a vulnerable position.

Changing course after failure

The VIX index, coined as the fear index, is currently demonstrating a complete absence of fear. Except for the occasional spike upwards this year it has been exceptionally low. The average level of VIX for this year sits in the lowest 5% in history (since 1991) with the current level being in the lowest 1%. Furthermore, the low of 9.75 this year was the 5th lowest in history, a level last achieved in late 1993. In the context of current world affairs and political instability, we believe this is demonstrating a worrying level of complacency amongst investors.

Recent spikes in the VIX highlight how this complacency can leave investors going short the VIX index vulnerable. The spike on 17th May is a good example. The VIX rose 46% from 10.6 to 15.6 overnight on the back of revelations that Donald Trump asked ex FBI Director James Comey to drop the FBI investigation into Russian involvement in the US Presidential elections.

From a superficial perspective, the low VIX suggests investors’ perception of future volatility is sanguine. We believe the VIX is understating risk. Our model of the VIX, which uses a combination of the Global Financial Stress Index (GFSI) and the US Economic Policy Uncertainty Index (detailed in VIX & Tax promises lulling equity investors into a false sense of security) highlights a widening deviation between our model results of the VIX and the actual VIX index. Our model suggests the VIX should be closer to 15, not its current level of 10.6. Thus, our model indicates that market perception of risk should be much higher. Perversely, we believe this disparity has been partly due to unstable macro events. A broad rise in the S&P500 is masking unusually low correlation between market sectors and individual stocks. This does not fully explain why the VIX has been deviating from our model, as this is a more recent phenomenon.

Since 2013 a worrying trend has arisen amongst a group of investors who are shorting the VIX. The subdued level of the VIX has likely been driven by investors, on the hunt for yield, motivated by years of loose monetary policy. The steep term structure gives these investors who are short the VIX a yield.

According to the CFTC (Commodity Futures Trading Commission), investors are holding record short positions – over 3x standard deviation from its historical range relative to long positions – suggesting shorting the VIX is an increasingly crowded trade.

We question how long this can last given the VIX is so low. We also remain concerned that an unwind of this trade will hurt, potentially prompting a VIX short squeeze and the resultant higher volatility prompting a risk asset sell-off. Timing a potential shift in sentiment is difficult although shorting the VIX will become increasingly less attractive every time the US Federal Reserve (FED) increases interest rates. The short VIX yield will therefore look increasingly less attractive as yields in other assets increase with rising interest rates. Conversely, an unexpected sharp move in equities or a significant political event could also precipitate an unwind in short VIX positioning.

On the other side of this trade are investors who see record lows in the VIX as an opportunity to buy long positions, fearing that volatility may rise. As illustrated by the shares outstanding from a selection of ETFs, short VIX ETF shares have been falling recently while long VIX ETF shares have risen sharply. This trend emerged not long after the first FED rate hike in December 2015.

The challenge in owning long VIX products is their ability to track the index. As the term structure is steep, it means as the products switch from one contract to the next, there is a cost incurred, meaning over time there is an increasing decay in relative performance.
The low measures of the VIX does have implications for the equity market. Historically there has been a poor relationship between the VIX and price/earnings (PE) valuations in the US, with a regression between of the two demonstrating an R-squared of 0.1 since 1990. However, over the last 2 years the R-squared his risen sharply to 0.58, suggesting a much closer correlation between the VIX and PEs.

The worrying aspect in the relationship is that the further the VIX falls, the higher valuations are, implying that investors are buying equities due to their low volatility, and are happy paying higher valuations to do so. As we believe the VIX is likely understating risk, this puts equity investors in a vulnerable position.

In short, we believe equity investors are becoming too complacent, valuations are high at a time when margins are likely to be squeezed further, whilst many promised corporate tax cuts may not come to fruition this year. Furthermore, we believe the VIX is lulling some investors into a false sense of security when holding equities. These factors leave equity markets vulnerable to a sell-off in the event of further interest rate rises and continued lack of clarity from the US political administration.

For more information contact:

ETF Securities Research team
ETF Securities (UK) Limited
T +44 (0) 207 448 4336
E info@etfsecurities.com

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Declining commodity prices drive a mixture of bargain-hunting and profit-taking

Declining commodity prices drive a mixture of bargain-hunting and profit-taking

ETF Securities Weekly Flows Analysis – Declining commodity prices drive a mixture of bargain-hunting and profit-taking

  • Bargain hunting sees US$79.7mn into long crude oil ETPs, the highest inflows in five weeks.
  • Third consecutive week of long gold ETP outflows.
  • Sterling shorts unwind post UK elections.

Download the complete report (.pdf)

Bargain hunting sees US$79.7mn into long crude oil ETPs. Crude oil slipped 3% last week as US inventories withdrawals continue to disappoint. Gasoline stocks increased, bucking seasonal trends. IEA data released last week shows that year-to-date OECD stocks have increased 360 kb/d despite OPEC’s efforts to cut back on production. OPEC figures show that the cartel’s production increased in May – a risk we have highlighted for some time. Oil is currently trading in the lower half of the US$40-55/bbl. trading range that the commodity has been stuck in. Bargain-hunting at these low prices drove the highest inflows in five weeks.

Third consecutive week of long gold ETP outflows. Outflows continue with US$27.2mn last week. Expectations for continued rate increases and central bank balance sheet normalisation in the US after a surprisingly hawkish statement from the Federal Reserve last week sent gold prices lower after peaking at US1295/oz on 6th June. However, as we observed in the previous week, geopolitical events can be supportive for the gold price. Gold tends to be the first port of call in the times of investor anxiety. The closure of the border between Saudi Arabia and Qatar, Ex- Director James Comey giving testimony to Senate, UK elections and Greek debt negotiations were all factors creating investor anxiety in previous weeks. Investors with an allocation to gold could find it a valuable event risk hedge. In the absence of shocks, however, we expect gold prices to grind lower, but the downside risk will be contained by the gradual nature of rate increases. Long silver ETPs also saw outflows of US$8.3mn, reversing part of the previous week’s US$14.2mn inflows.

Diversified commodity baskets see US$12.4mn outflows. Following the trend of falling net speculative positioning in commodity futures, we saw the third consecutive week of outflows from diversified commodity baskets. A stronger US dollar following the Fed’s rate move weighed on the commodity complex while oversupply in oil and fears of weak demand in metals haunt the asset class.

Sterling shorts unwind. Positions in short sterling/long US dollar ETPs fell by US$7.0mn as investors took profit on the sharp depreciation in Sterling after the UK general election on 8th June. The outflows remove most of the inflows from the prior week. While no progress has been made in forming a coalition nor strengthening the government’s hand in going into the Brexit negotiations, it appears the bad news is now priced-in. Indeed, with three members of the Bank of England now voting to raise interest rates last week, it appears the UK central bank is also getting more hawkish, which should provide some strength to the currency.

Video Presentation

Nitesh Shah Director, Commodity Research at ETF Securities provides an analysis of last week’s performance, flow and trading activity in commodity exchange traded products and a look at the week ahead.

For more information contact

ETF Securities Research team
ETF Securities (UK) Limited
T +44 (0) 207 448 4336
E info@etfsecurities.com

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