Place your bets on a September roller coaster
Equities, bonds coming off a quiet summer
As the CBOE Volatility Index has started to creep up in recent days, one of the market’s favourite August pastimes has begun: Betting on whether September, traditionally a volatile month, will be a market roller coaster.
Equities and bonds have until recently experienced one of their calmest summers in decades. Joe Amato, president and chief investment officer of equities at Neuberger Berman, notes that prior to last week, the S& P 500 Index had gone through 34 trading sessions without a 1 per cent one-day move, up or down. It only broke 0.5 per cent a total of six times — making it the least volatile 30 days in more than 20 years.
That is certainly a welcome respite following the whipsaw turmoil of the post- Brexit sell- off. It is also a far cry from last year’s performance, which was one of the most volatile Augusts in recent memory. A surprise devaluation by China of its yuan currency led the S& P 500 to record its first correction since 2011.
But volatility could be brewing. Markets are heading into a traditionally volatile season for stocks and bonds, and September will see a key U.S. Federal Reserve meeting. Previously, investors had expected no rate hike at that meeting, but comments made last week by Federal Reserve vicechairman Stanley Fischer have changed that.
These developments come against a backdrop of too much complacency, Amato says.
“Complacency is unwise — and not just because all of this could flip around by mid- September,” he said in a research note. “In financial markets, complacency itself can store up danger, increasing vulnerability to unexpected changes in conditions.”
Investors are still betting that the status quo will pre- vail. Data from the Commodity Futures Trading Commission shows that net short positions in the VIX have hit a record this month. The VIX rises as expectations of volatility increase, meaning investors see the VIX falling in the coming months if they are shorting it.
With expectations that the market will be a smooth ride for some time, Amato notes that the environment becomes riskier.
“Market volatility reverts to its mean, but even taking this into account, periods of unusually low volatility have often preceded bouts of unusually high volatility,” he writes. “Volatility was low just before the dollar came off the gold standard in August 1971, for example; it was low at the beginning of 2007 just before the financial crisis began to unfold; and it was low early in 2011 before the eurozone crisis erupted.”
“Low volatility didn’ t predict events like these, of course, but it created the vulnerability that explains some of the unusually high volatility when those events occurred,” he added.
Some analysts are recommending that investors load up on volatility ahead of a crucial policy month.
The Bank of America Merrill Lynch says investors, instead of joining the popular short- the-VIX trade, should bet that volatility is about to spike.
“With risk assets up 15-20 per cent since Feb., and Sep. a big ‘policy month’ we once again recommend buying volatility,” wrote a team lead by Michael Hartnett, chief investment strategist at BofAML.
Volatility could hit in a number of ways, says Hartnett, flagging the potential for a bond shock as one of the biggest risks. Simply put, investors aren’t positioned for multiple rate hikes by the Fed this year.
“Given that a lot could happen this fall to reveal how complacent and vulnerable markets have become — from an inflation or rates shock to another twist in the U. S. elections or a geopolitical tire blow- out — investors should make sure their seatbelts are fastened,” says Amato.