(Bloomberg) -- From wrong-way calls on bonds to Big Tech and the economy, it’s been an awful year for conventional wisdom. So when almost four in five Wall Street pros tell you the stock market is too calm, the savviest thing to do is to bet it stays that way.
That in a nutshell is the story of volatility trading at midyear, when everyone says they expect the VIX to rise, but everyone acts like it won’t. Warnings blare that the Federal Reserve and wobbly economy are sure to shatter the peace. And yet wagers that peace will prevail in the S&P 500 rose in June to the highest level ever, says Morgan Stanley’s sales and trading team.
Whether a ticking bomb or permanently defused one, the market is presenting unique challenges to speculators in 2023. With the Cboe Volatility Index averaging 14 in June for its sleepiest month since 2020, the potential for damage is extreme.
The risk is on vivid display just days into the second half. The fear gauge rose for a third straight session Thursday, jumping almost two points for the biggest increase since the banking turmoil in March, as hotter-than-expected data on the labor market spurred a selloff across financial assets.
Count Michael Purves, the founder of Tallbacken Capital Advisors, among those inclined to seek shelter. After advising clients to sell volatility most of the year, he’s now counseling caution, saying a nine month-long fattening of S&P 500 valuations is in jeopardy without more support from corporate earnings.
“We have been getting increasingly nervous about the VIX maintaining the 13-14 level,” he said. “We suspect as we get further into July, and earnings season kicks off, we should see the VIX stiffen up.”
He’s not alone. In a JPMorgan Chase & Co. survey of clients last week, 77% of respondents don’t expect the serenity to last over the third quarter. That sentiment is captured in a measure of the volatility of the VIX itself, the VVIX, which has stayed elevated.
The reporting season, set to kick off in mid-July, is expected to show profits from S&P 500 firms dropped for a third straight quarter with a nearly 9% decline from a year ago, analyst estimates compiled by Bloomberg Intelligence show.
The VIX tumbled 8 points to 13.6 in the first half of 2023. Going by the calendar alone, the odds of a short-term spike are long. July has been the calmest of all months since the VIX began. The index just closed below its long-term average — roughly 19.6 — for 14 weeks in a row, a streak not seen in three years. In all previous 16 instances of prolonged clam, the duration averaged 50 weeks, data compiled by Bloomberg show.
“Once we’re in a low-vol regime, it tends to last unless a true ‘unknown unknown’ comes along,” said Nick Colas, co-founder of DataTrek Research. “With the VIX well below average now, we look to be in a low-vol/good return environment until a genuine shock comes along.”
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Getting a firm grip on the trajectory of market volatility matters for options traders facing the conundrum of whether to double down on wagering on equity peace, or to take advantage of cheap pricing to hedge against turmoil.
Based on the consensus forecast from Wall Street strategists tracked by Bloomberg, the S&P 500 will drop 8% in the second half. Underlying the bearish case is the argument that while the economy has held up better than expected amid the Fed’s aggressive monetary tightening, the danger of a recession still looms large, posing a threat for risky assets.
Renewed market turbulence would threaten to turn a pivotal group of stock buyers into sellers. They’re the rules-based money managers, who typically use volatility as one major input in trading models and have been a major driver behind the latest equity rally.
Take volatility-target funds that make asset allocations based on price swings. Thanks in part to the stretch of market calm, they have poured more than $150 billion into equities in the past six months, according to an estimate at Charlie McElligott, cross-asset strategist at Nomura Securities International. By design, a volatility spike would force them to cut exposure.
To see where volatility is heading, it helps to understand why it’s been muted. One contributing factor to the VIX’s plunge is a lack of lockstep moves among stocks. For much of 2023, winners and losers have switched places and often offset each other, leading to a peaceful market on the index level.
A Cboe index tracking the three-month implied correlation among S&P 500 shares slumped in June to the lowest level since the month right before the February 2018 “Volmageddon,” an event where exchange-traded funds designed to pay investors the inverse of equity volatility folded.
Another driver is the resurgence of the once-troubled strategy of shorting vol. The trade is so popular that by one measure, the net amount of selling broke a record in April and did so again in June, according to Morgan Stanley’s team led by Christopher Metli.
That left options dealers — who are on the other side of the transactions and need to buy or sell stocks to maintain a market-neutral stance — in a “long gamma” position where they had to go against the prevailing trend, snapping up shares when they fell, or vice versa. The dynamic then resulted in a feedback loop that further suppressed volatility.
For those fretting over a repeat of the 2018 volatility implosion, Metli’s team offered some comfort.
“The recent pickup in SPX vol supply is unlevered, meaning that there’s less risk of a forced unwind in a shock,” they wrote in a note. “That stands in contrast to previous vol spikes.”
To Akshay Narayanan, head of equity options trading at Optiver, falling stock volatility reflects easing concern over economic threats. To him, the VIX’s future path likely depends on whether macro fears creep back as the dominant market force.
“Greater clarity on the Fed’s rate hike path, the direction of inflation, and to a lesser extent the impact of rate hikes on the economy have gotten rid of a lot of uncertainty in the market,” he said. “Potential triggers for a rise in equity volatility could include signs of inflation picking back up and geopolitical risks such as China/Taiwan.”
