VIX Below 10 Handle: Should Be Even Lower

The stock market had an amazing week as optimism surrounding earnings season pushed stocks higher. Investors are ignoring the nonsense in Washington because it’s mostly hot air. The fact that there disfunction in Washington instead of it easily passing bad laws caps the amount it can hurt stocks since nothing is getting done. The S&P 500 rose 0.47% on Friday, sending the Shiller PE up 30.11. That’s bad news for long term returns because margins usually mean revert. However, until margins stop accelerating we don’t have to worry about this. I’m expecting margin growth to decelerate in Q3 and Q4, but there needs to be a strong catalyst like economic weakness to bring them lower causing a bear market. The VIX had another selloff which is shocking in terms of where the VIX has been historically, but not surprising when you look at the recent trading in stocks. This year the VIX has averaged 11.54 in 2017 which is the lowest yearly average ever. The second lowest average was 12.42 in 1995.

The VIX is now at 9.51 which means it’s bringing the average even lower. The chart below shows why the VIX price isn’t surprising. The realized 30 day volatility is at 7.43 which is obviously lower than what the VIX trading at. I read a comment on Twitter where someone said that the opinion that the VIX is too low ignores realized volatility. While some may be ignoring this, I think the people who say the VIX is too low are predicting higher realized volatility because they think the market is too complacent. The blue line shows the VIX’s term structure which shows that many are expecting the VIX to rise closer to its long run average. Therefore, it is possible to make money by going long the VIX if you think it will stay near the level it’s at now.

To be clear, when I say you can make money by going long the VIX, I’m not saying I expect that to happen. As you can see from the chart below, the VIX’s seasonality is strong as it is often low in the spring and early summer and then starts to increase from August to November. Coincidentally, that’s when the Fed has decided to start unwinding its balance sheet and it’s when the ECB will announce the 2018 tapering. I’m not saying that the timing of these polices is bad because of calendar issues. I’m more focused on the potential changes at the Fed as this policy is about to kick in to high gear. Even if Trump appoints a dove, they might continue with the unwind if nothing goes wrong. Even Brainard, who is a big dove, recognizes that balance sheet normalization is coming. I think whoever is at the Fed will ‘play it by ear’ meaning keep it gong if there’s no strife in the stock market and slow it down if there’s a selloff.

It may be surprising, but I appreciate much of the analysis that the Fed does. My criticism comes from how the Fed uses the data it collects. As you can see from the chart below, the Atlanta Fed has calculated the Taylor Rule prescription, comparing it to the Fed Funds Rate. It’s somewhat surprising to see the Fed do this because it shows how wrong it has been with policy in the past few cycles. The Fed sets the rates too low causing a bubble. Then it raises rates too high, fostering a harder crash than would have occurred. The recession follows and then it repeats. This cycle the rates have been below the Taylor Rule for longer than ever. If you include the shadow rate, rates have been lower than the Taylor Rule than ever before. In the past few months, the rates have converged as inflation has fallen and the Fed has raised rates. We’re still in the sweet spot for stocks, but it’s ending. If Trump selects a hawk, it can end in 2018, causing a recession in 2019 or 2020. The catch 22 is that if the Fed doesn’t raise rates now, the bubble will grow. You can argue than the Fed should keep rates low forever, but when inflation rises, it will have to raise rates, causing a bigger crash.

Not only is there euphoria coming from the VIX’s realized level, but the short interest in the S&P 500 is now at 2007 levels which is right before the financial crisis. Keep in mind the arrows are a bit of a distraction because if you look at the whole chart, the short interest in late 2015 reached higher than the financial crisis despite there being no recession. I’m not implying that this chart along with the VIX means there will be a crisis soon, but it’s clear there won’t be another rush to invest in stocks like there was after the presidential election because everyone who wants to get in is in the market is in and all the short sellers are gone.

Conclusion

Even though it may look like a good idea to buy the VIX because it will probably go higher in the next few months due to seasonality and mean reversions, it doesn’t mean you should necessarily buy it. The contango is at 13.71% as the costs are high for holders of the $VXX and the $UVXY which go up when stocks go down. Betting on volatility has been the best suckers game in the market as traders think it must go higher because it has been so low this year. That’s a false pretense because there needs to be a catalyst for a market correction. With the Fed still in the sweet spot for the market and corporate earnings coming in strong, it’s not that obvious of a play. The market has been able to resist the worst possible headlines coming from Washington. While its probable that these headlines are exaggerated to gain views, it’s still a feat of strength for stocks to rally amid such disarray in the American government.

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