Implied Volatility

All posts tagged Implied Volatility

Let’s quickly dismiss the view that investors learnt from Brexit how to react to the election of Trump. US options are the world’s most liquid and the three month market that we track has consistently shown that President-elect Trump would be a sanguine outcome for stocks. Commentators are falling over themselves after the event to explain why this is, but OTAS has portrayed a consistent message of financial calm.

US Large Cap. Implied Volatility

US Large Cap. Implied Volatility

There have been three notable spikes in implied volatility over the past 16 months. Two of those, which we have labelled China and Recession, took this measure to exceptional levels, as fears mounted that a slowdown in Asia would cause the world economy to crater. The third spike, in the aftermath of the vote for Brexit, saw risk rise to unusual, but not exceptional levels. Politics may have rediscovered Paul Graham’s mantra that “It’s charisma, stupid” to explain which candidate wins a two-horse race, but the market remains firmly fixated on the economy.

By now we all have the received wisdom that Trump is good for certain regulated industries, such as banks and pharmaceuticals and his fiscal policies will mean more inflation and higher interest rates. The perceived riskiness of utilities relative to financials has jumped to unusual levels, last seen just before everyone remembered that Greece was about to default. With a while to wait to find out what Trump really stands for, big banks could be less risky than energy distributors for a while.

Implied Volatilty of Utilities Relative to Diversified Financials

Implied Volatilty of Utilities Relative to Diversified Financials

Central banks may have come to realise that forever easier money does not generate growth, but now they have the perfect foil to allow them to reverse course. Governors around the world have been beseeching politicians to do more to generate growth and the public has responded by electing those who promise to do something rather than nothing. There are incumbents who need to wise up fast. If Renzi’s reform bid fails then he may be gone, and if it succeeds and leads to a German imposed bail-in of bank depositors, then he’ll likely be gone a little later. The French also have an activist alternative to hamstrung mainstream politicians. Keep track daily of the implied volatility of the relevant markets and sectors with OTAS.

The chart of PE for the US top stocks suggests that the post-election move has room to run further and it would take a 7% re-rating to lift the valuation back to the highs of May 2015, when forward PE was last in touching distance of exceptional levels.

US Lage Cap. PE Valuation

US Large Cap. PE Valuation

One piece of received wisdom that is not playing out is that Trump will be unreservedly bad for trade and hence China and Emerging Markets. Mexico has taken a kicking, but perceived risk among China Enterprise stocks is almost unchanged. Once again it is fears of economic slowdown that floats this boat and clearly investors are not worried about a slowdown at present. Perhaps they believe that China wins relative to Mexico.

China Enterpise Implied Volatility

China Enterpise Implied Volatility

UK media is fretful the economy will suffer from trade restrictions. It is not obvious why Trump would single out the UK for harsh treatment when everything he has said points the other way and the immediate stock market weakness is likely to be currency related. The financial community in the UK is too savvy to confuse its own post-Brexit well-being with the health of the economy, when the opposite may be true. Keep an eye on implied volatility in the UK and be prepared to buy when threshold levels are reached. Threshold low PE ratios are also approaching.

One more thought going back to our blog of October 17, in which we argued that insurance stocks would be back in business once interest rate rises were on the cards. It may take a while for recalcitrant European central banks to get it, but the valuation of US insurance stocks in the last couple of days reinforces the conclusions we drew about what happens when they do.

US Insurance Sector PE Valuation

US Insurance Sector PE Valuation

After years of impasse, when the conclusion of culture wars rather than the economy occupied politicians, there are signs that activism is bringing markets to life. People worry that cultural change will be reversed, but let us hope that politicians and central bankers focus on the most important task of restoring growth for the benefit of all.

The plight of insurance companies in an era of low interest rates has led some to predict the total collapse of the industry. The sector is a bellwether for the stock market, because so much of its profit comes from investment returns. The chart of the PE of European insurers relative to the broader market shows that extreme valuation for the sector is a precursor of major market corrections.


European Insurance Valuation Relative to the Market

On this logic things are fine, because at two thirds of the average PE, insurance stocks have only just crossed into the normal valuation range following a period in the investment doghouse. This would tie in with our recent message that the prevailing investment trends are uncertainty over the direction of interest rates and gradually rising implied volatility back to normal levels. Relative implied volatility for the insurance sector peaks at index lows.

Implied Volatility of Insurance Stocks Relative to the Market

Implied Volatility of Insurance Stocks Relative to the Market

The woes of the insurance industry are easy to identify, which is why the sector is so popular among investment bloggers, who use it to point to the coming Armageddon in Europe, without having to offer too much analysis. Insurers depend on yield, all the more so as their customers age, so if central banks reduce bond yields to zero or below, insurance companies die.

You do not have to talk to those in the industry for too long to hear them bemoaning the new capital that is driving down returns for everyone. For the insurers, this is dumb capital that lacks the long-term perspective of their industry, but which thanks to light or no regulation has a lower cost of capital than incumbents. This is two different arguments; one about time horizons and another about the shadow financial sector.

Insurance is an industry whose last great innovation was the statistical analysis that brought about mortality tables. This allowed probability as a proxy for predictability and gave rise to a legion of highly specialised mathematicians with skills finely tuned to the needs of the industry. The maths can now be done faster and more effectively by computers, and so any cost advantage that new capital has from efficient operations is a permanent one. Whether you are regulated or not, you no longer need all those actuaries, just as investment banks no longer need so many analysts and lawyers don’t require all those proof reading juniors. Regulation actually serves to slow the loss of white collar jobs, because however onerous it may seem, all regulation favours incumbency.

The longer timeframe argument is more intriguing. Factor analysis shows that the inverse correlation between equity values and bond yields has weakened over several decades, most likely due to lower inflation, which had globalisation as its primary cause. The relationship has actually inverted since 2008, so that bonds and equities rise and fall in sync. Initial observations since 2013 suggest that the traditional correlation is reasserting itself.

This is due to the end of quantitative easing in the US and the political reaction to globalisation across the western world. Rising protectionism and constraints on immigration are the most evident backlash. These measures are designed to push up local wages and hence will be inflationary, and could herald the reversal of a long period of ascendancy of capital over labour.

It should be stressed that the jury is out on this. Most of our blogs reference the standoff between those who believe in the continuation of easy money and those thinking its time has passed, because this is the largest investment argument to be resolved. It is also one that OTAS indicators are ideally placed to track, including our fear gauge and low volatility performance monitor.

If the worm has turned however, and the ineffectiveness of monetary policy at the zero bound combines with political pressure to trigger policies that lead to higher interest rates, then the insurance sector will be back in business. Returns on insurance equities should discount this long before it happens. Those cautious mathematicians who have survived in the sector will have won the argument about the long-term, because underwriting in the industry should be priced using a higher cost-of-capital.

“It’s the devil’s way now, There is no way out

You can scream and you can shout

It is too late now, Because you have not been

Payin’ attention”

Radiohead 2+2=5

This week our Blog pulls together the themes and indicators from OTAS that we have been talking about for a while. We have been looking for clues that investors are losing faith in central bank omnipotence, which will expose those who do not adjust their portfolios from following the axiom of the past few years to a significant drawdown. There is a fierce debate among those who believe that judgement is coming and those who expect more of the same.

We tackled this issue in early September in what was probably my favourite blog, because the charts used to illustrate the points were the default charts that can be pulled up from OTAS with virtually no effort. For example, this chart of the average cost of credit for US large caps illustrates how credit risk has flat-lined this year, indicating a collective ambiguity about the direction of interest rates. Perhaps this is why the fiercest online investor arguments are about rates; because no one can be sure of where they are heading.

US Large Cap Average Cost of Credit

US Large Cap Average Cost of Credit

From here we developed the theory of Wall Street’s alternative fear gauge, where we used the relative volatility of banks and utilities to assess how relaxed investors were feeling about stock prices. In less than three weeks since then, the riskiness of banks, where low levels indicate an absence of fear, has fallen below that of utilities. This can hold true for several months, but it is not normal.

Relative Volatility of US Banks vs Utilities

Relative Volatility of US Banks vs Utilities

An obvious reason for the low relative riskiness of banks is that the odds of a US rate rise have increased, resulting in the dollar index breaking out of its recent trading range to the upside this week. Higher rates would raise banks’ margins, while hurting heavily borrowed utilities and diminishing the relative appeal of their dividend yields. This is a simple, but erstwhile effective investment conclusion.

Utility stocks are a stalwart of the low volatility portfolios that have been underperforming of late. This has led some to argue that the size of the unwind of the consensus trade in favour of low volatility and high yield will be the cause of the coming equity market fall. Last week we addressed the trigger point for index corrections in terms of the relative valuation of lower risk stocks. The sell-off in these names has pushed the riskiness of utility shares to extreme levels, which historically have not held for very long.

Relative Volatility of US Utilities

Relative Volatility of US Utilities

The mean reversion mechanism for this indicator is either that utilities lead and the rest follow in a coordinated meltdown in share prices, or the active few who trade relative volatility exit the stage, leaving the majority who passively expect the Fed to keep bailing them out to buy the dips.

The Radiohead song 2+2=5 references George Orwell’s 1984 and specifically Doublethink, whereby the state can compel citizens to believe something that is not true. For many investors it is axiomatic that stock prices will continue to rise, supported by easy monetary policy, because there is nowhere else for anyone to invest. The exchange rate related crushing that gold has taken this week reinforces this belief.

Radiohead subtitled their song The Lukewarm. This is a reference to those on the edge of Dante’s Inferno, who cannot figure out why they are there, because they didn’t do anything. For Dante, and the politically charged members of Radiohead, inactivity is precisely the crime for which these people are condemned. When you have an environmental activist in the family as I do, which makes Christmas colourful, you come to understand the charge sheet against the silent majority.

So who is more right; those who expect a major correction or those who believe that debt, deflation and an ageing population will result in years more pump priming by central banks. The reality is that both may be correct. A sell off in markets may be triggered by a rise in US interest rates, which could happen at the low point for our alternative fear gauge, which is now just a few points away. The resulting tumble could then trigger recognition of a policy error, leading central banks to resume the path of easy money.

In the first Blog referenced above we warned that CDS and implied volatility were sending conflicting signals. So far it is a correction in volatility that has addressed this discrepancy. US large cap CDS and implied volatility are two of the easiest charts to find and follow in OTAS. As Radiohead knew, there is no excuse for not payin’ attention.

Value is expensive. I am not sure that’s possible, etymologically speaking, although as it has happened it must be.

Investors are getting used to believing six impossible things before breakfast, as Lewis Carroll’s White Queen could. In a world of negative interest rates, this is the norm. Overnight I read another piece about Canada’s multiple investment bubbles and I am sure that one day they will all burst.

Timing, though, is everything. As a young man I worked in Malaysia during the frenzied stock market run of the 1990s. Each year more investors would come to visit (and shop), count the cranes building skyscrapers and return home bearish. One guy turned the taxi around within ten minutes of leaving the airport and took the next flight home. Eventually one of the visiting investors got their timing right. It would be nice to think it was the airport guy, but I can’t be sure.

Low value equates to low volatility. As this survey shows, low volatility is also low beta and financial strength. Yet over the long term, neither extremely low nor exceptionally high volatility delivers the best performance. That comes from stocks with middling risk.

This is logical. One test of any mathematical model is that it delivers intuitive results. Volatility is risk and if the lowest risk stocks always delivered the highest returns, then their price would be bid up to unsustainable levels. Equally, while risk and return are related, if constantly buying the riskiest stocks delivered the best performance, the word conservative would have fallen out of use.

How do we track this in OTAS? Median implied volatility for the largest stocks in the US is 24, which means that in three months’ time the average share is predicted to be up or down by 12%. The stocks with below average implied volatility have an average forward PE around 18x. This is a slight premium to the market.

PE Relative of Low Volatility Stocks

PE Relative of Low Volatility Stocks

Over time, the stocks that currently have below average risk trade at the same PE as the market. Not all of today’s low vol stocks will always have been less risky, but a lot of them will have been. The chart shows that when the PE premium in low risk stocks reaches 7%, the next move for the market is down.

There are arguments as to why low risk stocks might have the highest potential growth. Strong balance sheets leave scope for leverage and with all the free money sloshing around, buybacks can be used to raise EPS. But Q2 buybacks were the lowest for two years.

Alternatively, all the strongest stocks have the funds to invest in future growth, while the risky stocks have none and hence their earnings will fall. Also, low risk means low return, which equates to high current PE. And that is the point; when the PE of low risk stocks reaches a certain relative level, the low return element of the deal kicks in and stock prices fall.

This typically occurs when the market as a whole falls. When indices retreat from highs, the low risk stocks fall the furthest. Then a few more hedge funds close claiming the market to be irrational.

Canada’s still booming, there is tremendous demand for bonds that you pay to own and the least risky stocks have the highest expected growth. It’s not impossible that this continues, but history suggests that it is unlikely.

This week the Federal Reserve is expected to keep interest rates unchanged. Generally speaking, lower interest rates are considered a drag on the profitability of banks and a boon to leveraged investors such as utilities. This is because the two industries may be seen as opposites, as banks’ traditional role was to supply the debt that utilities used to fund power projects. Both institutions are highly geared, but one to rising rates and the other to lower.

The implied volatility of banks tends to rise relative to utilities at times of market panic. Not only is bank leverage higher than that of utilities, or any other sector, and hence the business model more risky, but the response of the Fed to market panics is to lower rates, which hurts bank profitability. This is a highly simplistic view of investing, but it is not hard to see how it has become a dominant one in a world of repeated accommodation by the Fed.

Bank risk relative to utilities

Bank risk relative to utilities

The chart shows the median implied volatility of banks in North America against that of utilities. In other words, it is a measure of how risky banks are relative to power companies. Typically banks are greater risk because the value of the index is over one, although in periods of high complacency such as Spring 2015, this was not the case. While the spikes in the chart show when selloffs in the market occurred, it is the periods prior to the spikes that we might contemplate.

The chart runs from the beginning of the second quarter of 2010 to date. There is no compelling rationale for this time period, but it illustrates neatly the periods of extreme weakness in markets and that the two most recent sell offs, in February and June, were mild compared with the late 2011 and mid 2012 events. Investors are pretty benign about the risks to banks relative to utilities at this point and, using this as a gauge of market sentiment, pretty pleased with how the market should behave through the next three months.

This may be surprising given the impending US elections and an Italian referendum that could become a vote on the EU and membership of the Euro. It does, however, show how reliant investors are on central banks keeping asset prices high.

Thus it is worth considering Ben Hunt’s latest missive, in which he puts the odds of Fed hike at three times those implied by consensus. Why should we pay attention to a lone voice when so many are of a different opinion? Because if the consensus consists of a majority that all thinks the same thing for the same reason, then it is dogma rather than the wisdom of crowds.

The other reason for contemplating what might happen should the Fed raise rates is another look at our alternative fear gauge. While bank risk relative to utilities rose last week, it remains at a low level, creating an asymmetric risk-return payoff. A few basis point on, rather than off interest rates, will not be sufficient to restore bank profitability, but it would probably be enough to cause a major rethink among portfolio managers.

Two articles published overnight indicate that the period of central bank omnipotence has ended. The Daily Telegraph carries this commentary on the ECB exhausting its ability to improve the Eurozone economy and this piece about the need for central banks to continue to project omnipotence, whatever the reality. One of our favourite analysts, Ben Hunt, has already declared  that central banking influence is on the wane.

Our recent blog on the logic of investors doubling up equity positions through the option market concluded that this strategy was rational when central banks are the primary influence over stock markets. It stands to reason that if this influence is on the wane, then the risks to equity exposure are mounting.

At OTAS we spend a lot of time looking at the indicators that may inform investors about a change in trend. One popular indicator is the level of credit default swaps, shown here for the median US large cap.

US Large Cap Median CDS

US Large Cap Median CDS

The lowest level of risk for US companies on this measure was June 2014. We have noted that this corresponded to the approximate peak in global export volumes and that economic momentum has deteriorated subsequently. The Fed indicated its taper strategy in December 2013 and officially ended bond buying in October 2014, but it was not until April 2015 that the cost of credit for US corporates began a meaningful rise. Credit risk has returned to its average level and stalled. This may indicate a reluctance to believe that the Fed can raise interest rates meaningfully.

US Large Cap Median Implied Volatility

US Large Cap Median Implied Volatility

Implied volatility is another favoured measure of risk. This also reached a trough in the summer of 2014 and showed a more meaningful pick up from Q2 2015. The reduction in implied volatility since February however, is at odds with the CDS risk indicator. This may suggest that the actions of investors are supressing volatility without the same degree of support from central banks as in the past. This is either because corporate earnings are on a growth trajectory, or because a bubble is forming based on past behaviour by central banks.

US Large Cap Median PE

US Large Cap Median PE

The PE valuation of US large caps is above its average range and on the verge of completing four weeks of decline from close to record highs this cycle. PE can fall due to rising earnings or falling prices and there is nothing to stop the two occurring simultaneously.

The situation in Europe sees the PE valuation of large caps at the very top of the average range. Relative to US stocks the valuation is mid-range, as shown below. The relative valuation has been rising since early July, which may be currency related. It does not, however, bear out relative rates of growth and is not factoring in that further ECB action may be detrimental to the economy, as suggested in the first article referred to above.

European Large Cap Median PE relative to US Large Cap

European Large Cap Median PE relative to US Large Cap

Our final chart shows the valuation of large cap UK stocks. This looks a lot like the US chart, albeit at slightly lower levels of PE. Short term positive EPS revisions are dominated by the Materials sector; much as Energy stocks dominate the list of most recently upgraded US shares. In Europe, ex the UK, without such a prominent resources sector, upgrades show no obvious sector bias.

UK Large Cap Median PE

UK Large Cap Median PE

The last month suggests that cracks are beginning to form in the equity bull market thesis. One rationale for this is that the power of central banks to influence stock prices is diminishing, perhaps at an accelerating rate. The bigger point is that monetary policy alone has been insufficient to drive an economic recovery that translates into corporate earnings rising as quickly as stock prices. One has to doubt that investors will afford politicians and fiscal policy the same perceived omnipotence as they have allowed central banks and monetary policy in recent years.

Sustained periods of low volatility correlate well with steadily rising equity prices. Yet concern is mounting that the current low volatility is storing up future problems, because investors are doubling up on high share prices. By selling put options on shares and indices, thereby committing themselves to buy shares should the prices fall, these funds are exposed to an equity market sell-off through both their ownership of stock and the recently written put options.

It is perfectly rationale to sell puts if you believe that markets are rising. The concern however, is that funds are so starved of yield that they are writing puts for the short-term income benefit and relying on the world’s central banks to bail them out should stock markets take a dive. A parallel is drawn with the sub-prime mortgage debacle, when it was not the size of the market for poorly underwritten mortgage loans that triggered the financial crisis, but the vast number of derivatives layered on top that magnified risk throughout the financial system.

US Implied Volatility - 2 Years

Implied volatility for the top 500 US stocks has fallen sharply since the post-Brexit panic and even more significantly since the worries about global growth were at their height in February. Yet as the chart above shows, two year implied volatility remains in its average range and around 10% above the successive lows of 2015.

US Implied Volatility - Longer Term

On a longer timeframe the shock from the financial crisis and its echo in 2011 are clearly visible, but the current level of implied volatility is not unusual in the post-crisis period when central banks have been deliberately dampening volatility in order to encourage risk-taking. Implied volatility for US large caps is 6% above the low point of its average spread. In Europe the picture is similar and implied volatility is 18% above the bottom end of its normal range, which has repeatedly marked the low point for this indicator.

Europe Implied Volatility

The charts appear to support the strategy of the put sellers, because implied volatility still has room to fall to reach previous lows, during which time the options sold will expire worthless. The put writers are also doing central bankers’ bidding by taking more risk, so they will feel justified in expecting central banks to bail them out when necessary. Large, long-only funds find it difficult to react to sudden moves in markets, meaning that they miss their chance to scoop up large quantities of shares before prices rally back to where they were. A logical way to ensure that these funds benefit from temporary corrections is to write puts so that they are guaranteed stock immediately prior to a central bank induced bounce.

There is a near-term benefit in enhanced portfolio returns because of the income from writing puts, but the longer-term gains are based on the assumption that central banks will continue to do what they have been doing since 2009. Janet Yellen may lay out the path to higher interest rates in her speeches, but as long as the Fed is seen to be ready to ease monetary policy whenever markets are in stress, the put-writing investment strategy will work.

OTAS users may keep a close eye on the trends in implied volatility to see when the current normal moves become exceptional. They should also look for confirmation from other indicators presented in a similar fashion, such as the cost of credit for corporates derived from the CDS market.


“Because as any coup-launcher or Fed-fighter or volatility-embracer knows, if you’re wrong on timing … you’re just wrong” – Ben Hunt, Epsilon Theory July 26, 2016

The number of short bets on sterling through the futures market is at a multi-year high ahead of next week’s expected cut in interest rates in the UK. While these may be the speculations of the same hedge funds that lost money on the UK referendum, there is a strong consensus that the pound is headed lower. As recent events have shown, this is putting UK companies in the shop window, but can OTAS provide a way of figuring out who is next to be taken over?

There have been strong suspicions and some academic research suggesting option market activity pre-empts M&A announcements. What the research cannot determine is whether trading was due to inside information or informed opinion. Typically it is out-of-the-money call option activity that is more informative than at-the-money or put options.

Before we look at the evidence from OTAS, will the Bank of England cut rates next week? This is a different discussion to whether it should. Jeremy Warner argues in the Telegraph that the sledgehammer-to-crack-a-nut response to a knee jerk, post Brexit survey of disappointed corporate Remainers is not the right way to run an economy. He points out that the acquisition of ARM Holdings funds the current account deficit for three months. Speculators may not be “fighting the Fed”, but they are battling investment flows.

The post referendum narrative is that the economically disadvantaged swung the result and new Prime Minister Theresa May has aimed her pitch squarely at where she believes this constituency lies. Politicians still fail to appreciate that many of those who feel left behind are middle class savers whose retirement plans are decimated by central bank group-think. Unfortunately, the prospects for this small-c conservative demographic are very poor, as explained by Ben Hunt in his latest Epsilon Theory.

If Ben is right and that nothing will stop the central banks from flooding markets with cash, as Brexit, data dependence and such-like are just excuses for more of the only thing the authorities want to do, then stocks should rise and the pound fall. Typically bull markets take place over longer periods than bear markets, and are associated with lower implied volatility as the direction of travel becomes more certain.

UK Large Cap Implied Volatility

UK Large Cap Implied Volatility

Implied volatility for UK large cap stocks is back in the average range of the past two years, but five points above the stable state of the first half of 2015 that saw UK stocks rising steadily. The two recent peaks reflect Brexit worries immediately before and after the referendum. The one before, which was a bigger shock regardless of what the media may tell you, was the global recession fears of February, now long forgotten in large part thanks to desperate/determined[1] action by the ECB.

The US market appears to be leading the UK, which is worth bearing in mind as the Brexit furore subsides and the Trump-panic-hype really takes off.

US Large Cap Implied Volatility

US Large Cap Implied Volatility

M&A activity may mean stock specific rises in implied volatility. OTAS shows that among UK large caps only BHP Billiton has seen such a rise over a month, while Anglo American and GlaxoSmithKline have risen over a week. This is based on at-the-money options, but OTAS users with desktop access may dig deeper to see at what level recent trading has taken place. The bulk of the activity for Anglo American, for example, has been out-of-the-money puts (no take-over expected here).

AAL 1-Week Exchange Traded Option Activity

AAL 1-Week Exchange Traded Option Activity

The chart for ARM Holdings shows that the take-over by Softbank was a surprise. The subsequent sharp fall in implied volatility reflects a done deal at a fixed price, while any continuing option activity is by arbitrage specialists using leverage to magnify small price movements.

ARM Holdings Implied Volatility

ARM Holdings Implied Volatility

There is much more to the option market than M&A. Specialist take-over investors will have lists of potential acquirers and targets and stay on top of many more factors than market signals. For the part-time speculator it is worth creating your own list of sectors and stocks that you believe could be vulnerable to approach were the pound to fall further. Putting these in a portfolio in OTAS will allow easy filtering for unusual activity, whether that is in the options market, dealings by directors, or idiosyncratic price performance.

For those interested in potential acquirers, checking the CDS of the companies may be a means of investigating which managements are planning leveraged take-overs. There are, however, other reasons why credit costs can jump, such as a shortage of cash from operations. For this reason, while OTAS provides an initial view on the world of potential M&A that goes further than press speculation, it is only suggesting stocks on which the user will need to do additional research.

Right now there is little unusual option market activity among UK large cap stocks. This may be because, as the quote at the top of the blog indicates, timing is everything. Or it may be because so few people seem to have been able to contemplate that the UK would have a corporate future outside the EU, any M&A activity comes as a complete surprise.

[1] Delete as per your preferred narrative

The rapid rebound in stock markets since the UK’s vote for Brexit is witness to two things. The option market, which is easily and effectively tracked using OTAS, expected little disruption through the vote and this is what has happened. Equally, investors anticipate another injection of liquidity from central banks to prop up asset prices, as the likely reaction to further shocks and as we discussed in April.

The debate about the efficacy of further central bank support was well underway before the UK referendum, as the protagonists knew the result was unlikely to change their opinions. A summary of the arguments is provided here, courtesy of Evergreen Gavekal’s weekly newsletter. At a time when the machinations of party politics are dominating the UK headlines and there is great gnashing of teeth at the absence of leadership, it is well to remember that central banks and not politicians have determined economic outcomes for many years, and it is their policies on which we must focus.

The optimistic case is put by Niall Ferguson, distinguished economic historian, who argues that the world’s central banks have coordinated their actions to stymie the rise in the dollar and end the currency wars that some believe will be the trigger for the next global downturn. If so, then the Bank of England Governor Mark Carney may have helped trigger a final competitive devaluation for the pound through his otherwise unseemly haste to declare his Brexit warnings as fact.  Sterling could be argued to have been held up by fumes, Brexit or no Brexit, given the UK’s gaping trade deficit and short-term financing requirements and the economy may benefit from the recent depreciation.

The pessimistic case, put by successful fund manager John Burbank, does not doubt that central banks desire to pour more fuel on the fire of monetary easing, but sees the policy as self-defeating. Where optimists cite Reinhart and Rogoff’s study of recoveries and the average eight years from financial peak to eventual recovery, the pessimists assume that the dollar will resume its rise and draw liquidity from much of the rest of the world in the process. Time will tell, but both camps appear sanguine short-term, which brings us to the three month predictions of the option market as deciphered through OTAS.


UK large stock implied volatility, a measure of risk or uncertainty, is at the top of its normal two year range. The post Brexit peak was lower than previous highs, including when Brexit first headed the polls and well below the February level, when global economic slowdown was the issue. While it is tempting to conclude that Brexit is no big economic deal, it is just as likely that investors expect evermore intervention by central banks. Thus the correct investment strategy remains to buy-the-dips, as it has been throughout the post-crisis years.

It is worth noting the frequency with which volatility tops out close to the two standard deviation level, marked by the upper solid blue line on the chart. While risk is not a normal distribution, the two standard deviation level remains highly instructive and statistical analysis provides a superior guide to upcoming investor behaviour than market commentary. The turning point normally comes when the noise level advising otherwise is at its zenith.

UK Stoxx IV

The recent disruption to the blanket volatility suppression undertaken by central banks does have a British flavour.  A week before the referendum, the relative volatility in the UK compared with the STOXX 600 matched the February peak and, again, was at a two standard deviation level measured over the previous two years. The post plebiscite peak did not reach this high, as it becomes increasingly apparent that uncertainty remains greater in Italy and Spain than in the UK (OTAS will show you this). Overall, UK large caps are barely more risky than Europe’s largest stocks and current relative risk is only a couple of percentage points above the average level.


Turning to Europe and a longer timeframe, implied volatility in the STOXX 600 remains safely mid-range over the past ten years, a result of continuing central bank activity and the insignificance of the likely long-term economic effects of Brexit on the UK or Europe. There is uncertainty, as many are determined to repeat, but the range of expected outcomes appears to be narrow. Note from the chart above how over this time period the one standard deviation levels, marked by the dotted lines, prove to be the normal resistance and hold in all but the most extreme trading environments.


The final chart compares current volatility in Europe to that in the US. Risk reduction is a global policy, but the biggest Brexit shock, which came before the vote, was enough to cause a spike in this measure from which markets have not fully recovered. By keeping a careful eye on the relative positioning of option investors in different markets around the world, OTAS users have a ready-made guide to what is most likely to unfold in equity markets. This should be of use as the news flow shifts to the potential for political uncertainty in the US later in the year.

With little over a day to go before the UK referendum, we present a last look at the state of play across equity markets using the multi-asset analysis within OTAS.

The pattern for the valuation of the STOXX 600 is established. At above 16.5x 12 months forward earnings the market is stretched beyond its normal range and has reverted in fairly short order. Much below 15x and the index attracts buyers, especially around 14x.

STOXX Jun 2016

This narrow range of values has persisted for many months and means that the Brexit vote in the UK is having little impact on investors’ views on the prospects for European equities. Rather investors should focus on 12 month EPS Momentum and the stocks being upgraded. A two-step filter within OTAS reveals nine shares in the STOXX 600 where upgrades were at least 5% in the last month and 10% in the past three months. Eight of these nine companies have EPS Momentum in the top decile across their respective sectors. Contact us for details.

STOXX CDS Jun 2016

The average cost of credit for European companies has been rising since March of last year, most likely to be when economic growth momentum was at its best. This is in spite of the ECB announcing and now launching purchases of corporate debt. Unless the cost of credit falls there is unlikely to be any change in productive investment across the continent’s listed sector, although recycling new debt into buybacks is one probable consequence of ECB action.

STOXX IV Jun 2016

Risk, as measured by three month implied volatility in the shares of Europe’s largest companies, has been rising gradually since September 2014. Even if we allow that the most recent spike to over 30 was Brexit related, the peak was no higher than the August 2015 move that took far longer to dissipate, and was well below the February 2016 period. At this time investors were focused on the risks of a global slowdown, so for all the publicity surrounding the potential damage Brexit could do to growth across Europe, equity option investors are dismissive of the risks.

The prevailing trends in European equities are a declining valuation, punctuated by central bank induced temporary recovery, mirrored by rising risk recorded in both credit default swap and equity option markets. This speaks to a gathering economic slowdown as a far more important trend than anything Brexit could cook up for European shares.

This is of course what the calm voices have been saying throughout the fractious UK debate, but calm voices don’t sell in the media and hence are easily drowned out by the ranting and raving of those using economic and market predictions for other ends.