Short VIX positions are at an all-time high, while net shorts are at an eight month high. For those not versed in financial speak, this means that investors are expecting a low level of volatility, or uncertainty, and that share prices are not expected to change much in the short to medium term.
Low levels of uncertainty are traditionally associated with gradually rising stock prices, because investors pay more when they are confident about the future. Central banks have attempted to crush volatility precisely to boost investor confidence, in the hope that this would spread to the broader economy. Whether this has happened is fiercely debated, but a leading investment bank tells us that more than 60% of US large companies are buying back shares, a similar level to the 2007 peak. This certainly helps offset any weakness in share prices when earnings disappoint.
The chart above shows that option traders expect US stocks to rise or fall by 12% over the next three months. There is no bias towards rising or falling in this analysis, but the chart clearly shows that implied volatility is at the low end of the average range over the past eight years. This is down by a third since February, when economic woes and earnings concerns were at their recent peak.
The February top had briefly exceeded the June 2012 high, just before Mario Draghi’s (in)famous “whatever it takes” speech. Since then, markets have been calmed once more, chiefly due to Draghi promising to buy up any piece of debt that investors in Europe can produce for him. The impact on volatility in Germany has been much the same as in the US.
Investors expect German stocks to rise or fall by 13% over three months, which is in lock step with US shares. This level of volatility is also at the low end of the long-run average range and has fallen by a little under a third since February. The February peak level also exceeded, briefly, the early summer 2012 jump in volatility that did much to trigger ECB action back then (the US having already acted long before to crush the extraordinary volatility of the financial crisis).
The chart tells us that volatility can fall further, in both the US and Europe and still be within the average long term range. At implied volatility of between 19 and 20 (+/- 10% three month share price moves) the US chart would be back at levels that were sustained from March to July last year. This was a period of high and stable values for the US stock market, but critically indices did not break through to new highs.
Once again, under the captive eye of the investment world, central banks have poured oil on troubled water and may succeed in coaxing markets back towards record levels. If so, this will have been achieved by creating copious amounts of money and having it buy back stock. The accumulation of debt for this type of investment, which has no obvious productive purpose, will do nothing for earnings growth other than create a dependency on even more buybacks next year if companies are to beat their earnings.
Once again, an extended period of low volatility is likely to be interrupted by a panic about economic growth and sustainability of earnings, and the investment world will turn to the central banks and demand another shot in the arm. By using OTAS to follow EPS Momentum changes and movements in implied volatility, traders and investors can expect to gain advance warning of impending moves.
