We can now add yet another entry to the long list of overly complex financial products that have been designed, built and levered before blowing up in investors’ faces.
For two years, equity markets kept going up and the best-known measure of implied market volatility—the CBOE Volatility Index, or VIX—seemed trapped, incredibly, below 10. Inevitably, structured products were developed to sell VIX futures and pick up the premium from being “short volatility.” Equally inevitably, the fact that the VIX was so low and the premium so tight led to more and more leverage being applied.
These products were so far over their skis that a modest sell-off in equity markets was enough to push the VIX to levels that sent them crashing down the slopes. Product providers had to buy futures to “cover” their ruined shorts, pushing the VIX even higher and turning the entire levered short-volatility trade into a snowball. At one point, the VIX hit 50. Remarkable.
It looked very painful from the sidelines, but do those of us investing in the “real economy” need to worry?
We don’t think so.
In fact, we think the current environment offers great opportunity for selling volatility, as long as it remains unlevered. If I could, I’d underline that last word three times in red. Neuberger Berman runs strategies like this, which have the potential for enhanced index returns with around two-thirds of the volatility. They behaved as anticipated last week and, as long as implied volatility remains elevated, they get the chance to “write” (that is, sell) put options for much higher premiums than a few weeks ago.
As my options-strategy colleagues Doug Kramer and Derek Devens put it: “The number one rule in options selling is to be humble with no (or very, very low) leverage, and not to get taken out.”
For those of us who take equity risk in the equity markets themselves, it is worth remembering that the S&P 500 Index finished January up nearly 6% and was overdue a correction.
Since the mid-2016 Brexit-driven sell-off, markets have risen 40% without so much as a blip. Markets never go up in a straight line, and every extended bull market has had meaningful corrections. While painful, these corrections are like taking a bit of bad-tasting medicine to maintain one’s health.
Momentum Still in Play
The momentum in economic fundamentals we were talking about in our last Asset Allocation Committee Outlook a month ago is still very much in play. We are set for another strong corporate earnings season and synchronized global growth likely has some months to run. Market momentum got interrupted last week, but in a perfectly healthy way.
The correction did provide us with an important clue about what might be cause for concern later in the year, however. The equity sell-off had its origins in fast-rising bond yields. These were boosted, in turn, by a much stronger set of U.S. employment and wage-growth data, which raised the prospect of higher inflation. The big wage increase secured by Germany’s metalworkers’ union last week was yet another closely watched indication that rising prices could be on the way. These are the conditions that often cause central banks to tighten policy—and kill bull markets.
Investor fear over that is premature, in our view. The market’s pricing of the Fed’s rate path for 2018 barely moved last week, and bond yields fell. While investors probably should demand a premium for the risk that the new guard at the Fed might blink in the face of some strong data, there is no sense that the central bank is behind the curve, or that bond yields are rocketing uncontrollably.
We regard last week as a timely lesson against becoming over-levered to economic and market momentum. But it is far too early to write that momentum off entirely.
In Case You Missed It
- ISM Non-Manufacturing Index: +3.9 to 59.9 in January
- Euro Zone Purchasing Manufacturing Index: +0.2 to 58.8 in January
- U.S. Purchasing Managers Index: Unchanged at 53.3 in January
- Bank of England Policy Decision: BoE has indicated that the pace of interest rate increases may accelerate if the economy remains on strong track.
What to Watch For
- Tuesday, 2/13:
- U.S. Consumer Price Index
- U.S. Retail Sales
- Japan GDP 4Q 2017 (first estimate)
- Thursday, 2/15:
- U.S. Producer Price Index
- NAHB Housing Market Index
- Euro Zone GDP 4Q 2017(second E=estimate)
- Friday, 2/16:
- U.S. Housing Starts and Building Permits
Statistics on the Current State of the Market – as of February 9, 2018
|S&P 500 Index||-5.1%||-7.2%||-1.8%|
|Russell 1000 Index||-5.1%||-7.1%||-2.0%|
|Russell 1000 Growth Index||-4.9%||-7.1%||-0.5%|
|Russell 1000 Value Index||-5.3%||-7.1%||-3.5%|
|Russell 2000 Index||-4.5%||-6.1%||-3.7%|
|MSCI World Index||-5.5%||-7.3%||-2.4%|
|MSCI EAFE Index||-6.2%||-7.4%||-2.8%|
|MSCI Emerging Markets Index||-7.1%||-8.9%||-1.3%|
|STOXX Europe 600||-6.4%||-8.3%||-3.3%|
|FTSE 100 Index||-4.7%||-5.8%||-7.7%|
|CSI 300 Index||-10.1%||-10.2%||-4.7%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.2%||0.2%||-0.1%|
|Citigroup 10-Year Treasury Index||0.1%||-1.0%||-3.4%|
|Bloomberg Barclays Municipal Bond Index||0.2%||-0.2%||-1.4%|
|Bloomberg Barclays US Aggregate Bond Index||-0.1%||-0.8%||-1.9%|
|Bloomberg Barclays Global Aggregate Index||-0.4%||-1.2%||0.0%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||-0.3%||-0.2%||0.9%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-1.4%||-1.9%||-1.2%|
|ICE BofA Merrill Lynch Global High Yield Index||-1.5%||-1.9%||-0.6%|
|JP Morgan EMBI Global Diversified Index||-1.9%||-2.5%||-2.5%|
|JP Morgan GBI-EM Global Diversified Index||-1.8%||-2.3%||2.1%|
|U.S. Dollar per British Pounds||-2.2%||-2.9%||2.1%|
|U.S. Dollar per Euro||-1.5%||-1.7%||2.0%|
|U.S. Dollar per Japanese Yen||1.6%||0.4%||3.6%|
|Real & Alternative Assets|
|Alerian MLP Index||-4.4%||-6.4%||-1.0%|
|FTSE EPRA/NAREIT North America Index||-3.7%||-6.6%||-10.2%|
|FTSE EPRA/NAREIT Global Index||-5.6%||-7.8%||-6.5%|
|Bloomberg Commodity Index||-3.9%||-4.6%||-2.7%|
|Gold (NYM $/ozt) Continuous Future||-1.6%||-2.0%||0.5%|
|Crude Oil (NYM $/bbl) Continuous Future||-9.5%||-8.5%||-2.0%|
Source: FactSet, Neuberger Berman.