Since Christmas Eve, stocks have been on a quiet tear with the S&P 500 climbing around 12% since then. But while stocks are now rebounding after being clobbered for the last several months, don’t be fooled.
“Don’t think stocks are back to their old ways of just chugging along and making easy money,” Nick Colas, co-founder of DataTrek Research, said in an interview with Yahoo Finance. “The recent rally is likely due to the end of tax loss selling as we crossed over into the new year.”
There are also several volatility markers that seem to be signaling a warning about what’s to come.
The first is a divergence between the VVIX Index and the VIX which indicates that investors aren’t betting on a new breakout with outsized price moves, which could be a sign of complacency.
Credit Suisse Group AG strategist Mandy Xu warns that markets are “vulnerable to bursts” of volatility in 2019. And that’s certainly been clear recently as U.S. stocks have been bouncing around quite a bit.
Right now, the 50-day moving average of daily price swings in the S&P 500 is close to its highest levels since December 2008.
“The increasing use and gain in popularity of weekly S&P 500 options—and SPY and e-minis—are potentially one important contributor to the intraday volatility of the S&P 500,” Kambiz Kazemi, a partner and portfolio manager at La Financiere Constance in Toronto, said.
According to Kazemi, as an index approaches levels where the option strike price shows high open interest, hedging has a tendency to expand quickly which could lead to abrupt accelerations in the underlying gauge.
A chorus of voices heading into the new year warned that investors should prepare for a difficult 2019 and recommended hedging appropriately. But recently, hedges are the cheapest they have been since 2016, and muted premiums for traditional protective hedges over upside calls is another signal worth keeping an eye on.
Implied volatility for put options on the S&P 500 Index sunk late last year relative to call contracts, which sent the CBOE SKEW Index—which measures expectations of a tail event—to its lowest level in more than two years.
Strategist can disagree on what the falling SKEW means and say that it indicates either a rush of bullish bets in anticipation of a big rally, or a complacent shunning of market defenses.
Demand for hedges jumped last February as investors looked for safety in bearish contracts. However, that wasn’t the case in the fourth quarter as stocks tumbled and the SKEW gauge fell.
“This dynamic has very much been to the frustration of several clients, who were unable to monetize hedges to the degree of profitability that they had presumed they would,” Andrew Scott of Society Generale SA said.
The one bright side to this is that downside hedges are rarely as cheap as they are now.
Finally, bonds too are raising eyebrows, as the world’s largest bond market has become a bit too calm.
A volatility gauge for the 10-year U.S. Treasury futures “now screens a touch low,” warns UBS Group AG strategist Stuart Kaiser. And a breakout in interest-rate volatility is a leading indicator for shifts that are unfriendly to risk assets.
