It has been widely reported in the media that selling volatility has been on the rise among traders. The VIX (S&P 500 Volatility Index) is at historic lows, with equities seeming to shrug off negative data. Volatility ETF/ETN products are a popular (and easy to transact) way to speculate on market calmness. This week, SVXY (ProShares Short VIX Short-Term ETF) was especially active in the securities lending market. SVXY carries a borrow fee of 2.5%, with Utilization at nearly 95%. Small primes are showing size today, we are not seeing anything from bulge brackets or retail.
SVXY seeks daily returns which correspond to the inverse of VIX performance. Shorting SVXY is akin to buying volatility – betting that there may be a drawdown in the stock market. So why do traders pay 2.5% to short SVXY when they can just buy VIXY (ProShares VIX Short-Term Futures ETF ), also a long volatility play, with zero borrow cost? One answer is decay. Due to the structure of volatility products, inverse funds experience price decay as the fund rolls its positions to match the underlying index results. Vanilla volatility funds also experience decay, but at a lower rate. The trading strategy for SVXY shorts is to bet on volatility rising, while potentially profiting from fund decay while waiting. This has not been a profitable trade this year. SPY realized volatility (7.8 10-day for Q2) has been consistently lower than Implied (8.83). SVXY’s share price has doubled YTD.
For information and risks about short selling volatility products, please review this link from the IB Knowledge Base.
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Professionals have combined these three data points to justify higher NASDAQ-100 Index (NDX) prices:
The third observation is most noteworthy if you are calling for higher broad-market prices. Here is why:
We hold the view that the US dollar and crude oil are the most significant driver of asset prices in the world, everything else is just a byproduct of their direction.
The US dollar is in a clear downtrend.
The road map from profiting from a falling US dollar historically looks like this: invest in US exporters, tangible assets (foreigners who buy U.S. real estate or commodities) and appreciating currencies or stock markets.
The idea that foreigners buy US real estate, or interest rate sensitive equities (i.e. the financial sector), or commodities (i.e. energy, materials), if correlations turn even more positive with the technology sector (i.e. US exporters) is not discounted in the market, especially by quantitative or pairs trading strategy that are long on technology and short of energy.
The major equity indices are soft across the board in what appears to be a natural consolidation after recently making new all-time highs. One group making fresh new highs is the insurance industry. The insurance ETF, ticker KIE, has been up in eight of the prior nine weeks. This week the KIE has broken out above the prior 52-week high, $89.50, made back in early March, which represents the neckline of a cup and handle pattern. The size of the pattern projects a measured move towards $95, +5.4% from last sale. Momentum is elevated with the daily RSI at 68 suggesting a period of consolidation could occur soon which may provide a more attractive entry for new longs.
In the months following the election, we saw optimism surge higher in a number of prominent indicators…
The thinking was as follows: a new era of higher economic growth was about to take hold, driven by lower taxes, deregulation and massive infrastructure spending. It was said that 5% real GDP, a stronger U.S. dollar, higher long-term interest rates, and higher wage growth were coming.
Reinforcing this belief was the booming stock market in the U.S., hitting new all-time highs on a daily basis and doing so with just about the lowest volatility in history.
Fast forward to today and the stock market continues to hit all-time highs with record-low volatility, but something interesting is developing with respect to the aforementioned levels of optimism. They are starting to move back down…
But these are just surveys. Perhaps the real economic data is painting a different picture. Let’s take a look…
Based on the data, it would be hard to argue that economic growth is improving, and certainly not supporting the belief that 5% real growth is attainable anytime soon. If anything, growth appears to be slowing down just a bit.
Meanwhile, the U.S. Dollar Index is at a 52-week low, down against every major currency in 2017.
And long-term bond yield have fallen in 2017 while the yield curve (10-year minus 3-month yields) is close to its flattest level of the expansion. The bond market certainly is not buying into a move to 3% real growth, let alone 5%.
But we still have the stock market, hitting new all-time highs on a daily basis with no volatility to speak of. In contrast to the economic surveys, sentiment there has certainly not waned. Is this a signal that 5% growth may indeed be coming? Only if you believe the stock market is the economy.
In recent weeks, the President has suggested as much. Mr. Trump, who called the entire stock market advance under President Obama a “big, fat, ugly, bubble,” has been touting it as a barometer of success…
It would be an understatement to say that there has been no President in history who has mentioned the stock market with greater frequency. This is interesting, for if the stock market is said to be a real-time reflection of his performance, what will the President say when it actually goes down (there hasn’t been a 5% correction since he was elected, one of the longest stretches in history)?
As most market participants understand, the President and their policies have very little influence on equity returns. There are a multitude of factors that drive the stock market (earnings, valuation, sentiment, economy, etc.), and the President is just one microscopic piece of that puzzle. This is as it should be in a free market economy, where no one person has undue influence.
Considering the growing divide between the stock market and the real economy, the question for investors is whether they still believe the post-election narrative to be true. Will the dream of 5% growth be realized and do they take Trump at his word when he says: “we’ve signed more bills – and I’m talking about through the legislature – than any President, ever”?
Rational optimism is the best default mindset to have and has served me well throughout the years. But there are times when optimism reaches a point that is simply not supported by the data, hence becoming irrational. After the election, the homebuilder/consumer/housing/manufacturing surveys were at such a point. In recent months they seem to be slowly coming back to reality, understanding that there was no paradigm shift on election day.
Will the stock market be next?
As of 11:45AM
US stocks are weaker this morning following the downtick in other markets across the globe. The Euro/USD continues to move higher today, as concerns the US economy might not benefit from the president’s plan to catapult the economy in the near-term. All 11 S&P sectors are in the red, on higher than normal volume (options expiration Friday). Crude Oil (-1.5%) is suffering its largest pull-back in 2 weeks, and applying pressure to Oil and Gas (-0.75%) stocks.
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