Steven Merrell, Financial Planning: A little perspective on market volatility

Feb 12, 2018, 00:28
Steven Merrell, Financial Planning: A little perspective on market volatility

"Equity markets have finally woken-up after a period of low volatility and complacency that had led to rapid gains", said James Knightley, chief global economist at ING.

The epicenter of the selloff was in the highly leveraged world of exchange-traded funds and related products, where investors had successfully bet for years on market volatility remaining extraordinarily low for long periods.

The Vix index should reflect this in the coming days.

Monday's slump in the US stock market may have been painful for those betting against volatility in prices, but traders who took opposite positions hoping to gain from a sharp move are likely to laugh all the way to their banks. One of the big money-making trades on Wall Street since 2015 has been to sell volatility.

Barclays also told clients that the spike in the VIX index - the S&P 500's fear gauge - was "technical in nature and does not necessarily indicate a true increase in risk perception". The markets were placid and traders were sanguine.

BIGGEST TWO-DAY SPIKES IN THE VIX A historical look at the VIX suggests that spikes such as the ones witnessed on Monday are rare. The S&P last corrected in January 2016.

Last Friday, the stock market suffered its largest daily drop in more than two years and volatility surged. At one point on Monday, the Dow Jones Industrial Average dropped more than 6 percent inside of 6 minutes. But during the market rout on Monday, it soared to 38.8, its highest level since August 2015, and rose by a record amount.

Davide Silvestrini, EMEA Head of global quantitative and derivatives strategy at JP Morgan, said the sharp losses experienced by short vol strategies will likely lead to reduced volatility selling flows from institutional investors. Once volatility started rising, these funds were forced to cover their short volatility positions. The resulting activity put tremendous pressure on stocks which further exacerbated volatility and kicked off a self-reinforcing spiral. As the following chart shows, the drop that followed across the globe wiped out $4 trillion in world stock market capitalization, and world stocks have reversed their 2018 gains. They bring discipline and help keep Wall Street hubris in check. Do all you can to understand what is happening as corrections unfold.

Steven C. Merrell is an investment adviser and partner at Monterey Private Wealth, Inc., in Monterey.