With option prices in the doldrums, your host provides some thoughts on why and in the process reflects on the skinny levels of risk premia a decade ago. I finish with some cautionary observations around what might go wrong. I hope you enjoy this short pod!
[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics
[00:00:07] in financial markets associated with managing risk, generating return, and the deployment
[00:00:12] of capital in the alternative investment industry.
[00:00:20] The Zeros is a 2014 movie clocking in at just 72 minutes but scoring an impressive 8.4
[00:00:27] out of 10, at least in one ranking.
[00:00:29] Like a fabulous bromance, 22 Jump Street, the Zeros celebrates its 10-year anniversary and
[00:00:35] somehow also escaped an Oscar nomination.
[00:00:38] Oh, the politics of the academy.
[00:00:41] The Zeros was relevant in 2014 not just in the theater of movies but also in the theater
[00:00:47] of markets as well.
[00:00:49] By the middle of that year with Bernanke's forward guidance regime, the law of the land,
[00:00:53] vol buyers had learned their lessons.
[00:00:55] The GFC, the flash crash, the Euro-Sov crisis and even the taper tantrum in the rear view,
[00:01:01] there wasn't enough to worry about.
[00:01:03] Russia annexes Crimea?
[00:01:06] Good for a small pop in the VIX but even this came and went.
[00:01:09] By mid 2014, the vol of nearly every asset class was on its back registering near the
[00:01:15] zero percentile.
[00:01:17] Sure the VIX had been lower before, credit spreads too, but come on, late 2006 made
[00:01:23] for a nearly impossible comp.
[00:01:25] Empowered by a self-fulfilling process of housing price appreciation and the leverage built around
[00:01:30] it, a signature aspect of the pre-GFC system was to push risk-premia to unimaginably low
[00:01:37] levels.
[00:01:38] It's what generated the market to market wealth to keep the charade going.
[00:01:41] But in contemplating the low vol of 2014, let's bring in three other asset classes
[00:01:46] – rates, FX and commodities shall we?
[00:01:50] In the Treasury market, the setup was one of not just low policy rates but prices that still
[00:01:55] reflected the hard promise to keep them there.
[00:01:58] Recall Bernanke's tapering isn't tightening spin on things by late 2013.
[00:02:04] Aimed at molifying markets, his memory of the misbehavior of asset prices still front
[00:02:09] and center.
[00:02:10] Central to Bernanke's get out of jail free card at that time was highly benign inflation
[00:02:15] data.
[00:02:16] At the end of 2013, Core PCE registered just 1.5%.
[00:02:20] You see, there's no rush, said the bearded gent checking his Bloomberg screens in the
[00:02:25] process wishing he could short the VXX.
[00:02:29] By mid-2014, the two year had rallied back to around 35 basis points.
[00:02:34] The move index was below 60.
[00:02:37] How about FX vol a decade ago?
[00:02:39] Here's another zero percentile that is.
[00:02:42] The CVIX registered around 6.
[00:02:45] Markably, three month implied vol in the euro was just north of five headed below it a month
[00:02:50] later.
[00:02:51] This had gotten as high as 17 during the bad days of the eurozone crisis in September
[00:02:55] 2011.
[00:02:57] Late night summits, Michael Lewis misives telling us to beware of Greeks bearing bonds,
[00:03:03] Silvio Berlusconi sleeping on the job and John Claude Junker famously saying, quote,
[00:03:09] when things get serious you have to be prepared to lie.
[00:03:12] What a time that was.
[00:03:14] But by mid-2012, Mario Draghi arrived on the scene, gained control of market prices through
[00:03:19] both words and deeds.
[00:03:21] By the middle of 2014, six month realized vol in the euro was five.
[00:03:27] And what about crude?
[00:03:28] Its 2014 behavior offers lessons aplenty on risk.
[00:03:32] Who can forget the epic supply glut that built up during the shale revolution?
[00:03:38] Prices would get to 110 by 2013 and hovered around 100 by the middle of the following
[00:03:44] year.
[00:03:44] Realized vol faded and by mid-year was below 15.
[00:03:48] And the realized vol of the realized vol plummeted as well.
[00:03:52] Hedge funds conditioned on profiting not just from consequential daily moves in crude
[00:03:57] but also from periodic changes in the vol environment closed shop.
[00:04:02] It would change dramatically later in 2014, but by mid-year three month vol on crude
[00:04:07] registered at a can you believe it level of 14.
[00:04:12] To be sure, every year brings its share of drama, but boy there was a lot going on in
[00:04:17] energy production in 2014.
[00:04:19] Who can forget the man camps of Balkan, North Dakota?
[00:04:23] And how about some of the big winners?
[00:04:25] A May 2014 New York Times article proclaimed Harold Ham, the billionaire oil man fueling
[00:04:30] America's recovery.
[00:04:32] His 70% stake in continental resources left him worth 16 billion at the time.
[00:04:38] The price of crude and the price of continental would plummet a year later.
[00:04:42] He'd also be divorced a year later, cutting a check for nearly one billion to his ex.
[00:04:47] The largest settlement ever by the way, Melinda and Bill Gates for 76 billion.
[00:04:52] As Peter Claven said to his bestie Sydney Pfeife in I Love You Man, that's a lot
[00:04:56] of quiche, a lot of cake.
[00:04:59] On the commodity front, gold vol was also quite low by mid-2014 with a three month
[00:05:04] reading in just the 10th percentile over the last five years.
[00:05:08] Did I mention that three month implied vol on live cattle was also in the 10th
[00:05:12] percentile at the same time?
[00:05:14] I do digress, but you can check it out yourself using the Bloomberg ticker IVOLCATT.
[00:05:21] So if we put it all together, equities, rates, credit, FX and commodities, we had
[00:05:26] a protracted meltdown in the price of insurance by the middle of 2014.
[00:05:32] The zeros played out, not just in the movies, but in markets as well.
[00:05:36] Is it any wonder that Bill Gross was reportedly short 60,000 strangles on the
[00:05:40] big S&P in early summer 2014?
[00:05:43] SciZola.
[00:05:45] Fast forward to 2024 and the zeros is back for a cross acid sequel.
[00:05:50] Let's put this in some context with an index we might label the jump.
[00:05:54] As the famous song by Van Halen celebrates its 40th anniversary this year,
[00:05:59] markets are hardly exhibiting any jump.
[00:06:02] In fact, an equally weighted index of 10 assets, FX, SPX, Euro stocks, move, crude,
[00:06:08] gold, IG and high yield credit spreads, high yield implied vol and vol-a-vol scores
[00:06:14] a paltry 18.5 as of this writing.
[00:06:17] That is the average five year percentile of one month implied vol or
[00:06:21] spread of these 10 assets.
[00:06:23] The only two approaching 50 are the move and gold.
[00:06:27] And we didn't include it, but do not get me started on the depressed option prices
[00:06:31] on milk futures.
[00:06:32] Don't do it.
[00:06:34] In all seriousness, not included in the jump, which by the way,
[00:06:38] because Wall Street can't get away from tortured backfilled acronyms, stands for,
[00:06:42] wait for it, joint uncertainty in market prices.
[00:06:46] Crensh?
[00:06:47] Not included in this metric is implied correlation in the S&P.
[00:06:51] Talk about an unloved asset.
[00:06:54] Before we dive in, this metric is one of so many implied measures that the
[00:06:58] wonderful ecosystem of prices yields, implied vol, implied correlation,
[00:07:03] implied borrow, implied dividends, implied rate hikes, implied forwards,
[00:07:07] implied inflation, implied earnings move.
[00:07:10] I'm sure I missed a few.
[00:07:11] But what we should love about market prices, mostly from the option market,
[00:07:16] is the matter in which they yield specific information that we can then
[00:07:19] debate.
[00:07:20] I say it often that market prices aren't so much a predictor of where things are
[00:07:24] going, but are simply clearing levels that bring the buyer and seller to the
[00:07:28] table at a moment in time.
[00:07:29] In early January, market prices had the Fed cutting almost seven times in
[00:07:33] 2024.
[00:07:35] By mid-year implied eases are not even two.
[00:07:38] From a pure prediction standpoint, implied prices may not materialize and
[00:07:42] they actually turn out to be wildly incorrect.
[00:07:45] At the start of 2007, two year implied vol in the S&P was 15.
[00:07:50] What was the realized vol over the ensuing two year period?
[00:07:53] 32.
[00:07:54] Whoops.
[00:07:55] In the same way that implied volatility is the filler that forces the model
[00:07:59] price of an option to equal the observed market price given the known
[00:08:03] variables, implied correlation connects the price of an index option to the
[00:08:08] price of the options on the single stocks within that index.
[00:08:11] All things being equal, the implied vol on an index is going to be less
[00:08:15] than the average of the implied vols on the constituent names in it.
[00:08:19] The implied correlation metric helps us answer the question, how much less?
[00:08:24] If the index vol and average stock vols are the same, implied correlation is in a
[00:08:28] back of the envelope calc 100.
[00:08:31] The market is willing to pay up for the index option mostly because the
[00:08:34] stocks are so correlated that there's near zero loss of vol at the index
[00:08:38] level from diversification.
[00:08:41] When has implied correlation been incredibly high?
[00:08:43] 2008, 2011, and 2020 are three solid examples.
[00:08:48] Motion comes with crisis, one might say.
[00:08:51] Today's setup is incredibly different.
[00:08:53] Stocks are zigging and zagging in a way that is unique even adjusted for
[00:08:56] a bull market.
[00:08:58] Let's take the five super caps that flow to top the SNP, Apple, Microsoft,
[00:09:02] Nvidia, Google, and Amazon.
[00:09:05] Just 13 trillion of market cap, no biggie.
[00:09:07] The total market cap of the index is around 45 trillion.
[00:09:11] One percent of the stocks comprise nearly 30 percent of the
[00:09:14] market cap.
[00:09:16] Sounds top heavy to me.
[00:09:17] But what is so interesting about these five
[00:09:19] is how minimally they are correlated.
[00:09:22] Over the last six months,
[00:09:23] the simple average of the pairwise correlations is 42%.
[00:09:27] That's among the lowest reading on record
[00:09:29] over the last decade.
[00:09:30] Why?
[00:09:31] Well, in search for some explanation,
[00:09:34] it's difficult not to see the one day 16% surge
[00:09:38] in NVIDIA on February 22nd.
[00:09:40] A move that large with little follow through
[00:09:42] from the other four
[00:09:43] is going to wreak havoc on realized correlation.
[00:09:46] Apple rose a modest 1.1% on February 22nd.
[00:09:51] Let's pull up a quick comp.
[00:09:52] On October 14th, 2008, Bank of America
[00:09:55] soared by exactly the same 16%
[00:09:58] as NVIDIA did earlier this year.
[00:10:00] What were the moves for related companies on this day?
[00:10:03] Goldman jumped by 10.7%,
[00:10:06] Morgan Stanley by 21.2%,
[00:10:08] and Citi by 18.2%.
[00:10:11] Ah, the correlations they come and go, don't they?
[00:10:14] Today's poultry level of realized correlation
[00:10:17] among the super caps comes at a time
[00:10:19] when volatility of the stocks is also quite low.
[00:10:22] The average of the six month realized volatility levels
[00:10:25] on these five corporate beasts is just 28%.
[00:10:28] Again, one of the lowest readings over the last decade.
[00:10:32] In combination, depressed levels of stock volatility
[00:10:35] and the correlation that the market is willing to pay
[00:10:37] for an index option like the S&P
[00:10:39] makes for some pretty skinny option prices.
[00:10:42] But as a wise man once said,
[00:10:44] there's no crying in correlation.
[00:10:47] What do we know?
[00:10:48] The same conditions that lead
[00:10:49] to an increase in single stock volatility
[00:10:51] also cause stocks to become more correlated.
[00:10:54] The big macro sources of uncertainty
[00:10:57] are kind of always there
[00:10:58] and we get tired of hearing of them.
[00:10:59] In fact, as they are recounted daily
[00:11:01] with no follow through in the prices we stare at,
[00:11:04] our ability to sense danger may be compromised.
[00:11:08] This seems like a good time for a quick aside.
[00:11:11] By now you recognize my fascination
[00:11:13] with days of consequence and markets.
[00:11:15] It's interesting and valuable to look back
[00:11:18] on the big moves trying to learn from them.
[00:11:20] Approaching soon is June 11th
[00:11:22] and with that the four year anniversary
[00:11:24] of a nearly 6% plunge in the S&P in 2020.
[00:11:28] Since 1990, this is the 14th largest one day decline
[00:11:32] in the S&P.
[00:11:33] COVID was still very much a health and employment crisis
[00:11:37] but the intense fire of asset prices
[00:11:39] had largely been put out by June of 2020.
[00:11:42] Outside of the GFC and pandemic crashes,
[00:11:45] there are only three larger one day moves.
[00:11:48] The Southeast Asian FX crisis in 97,
[00:11:52] LDCM in 98 and the Eurozone sovereign crisis in 2011.
[00:11:57] I often say that Val has memory and Val mean reverts.
[00:12:01] On the memory front, we know that high Val periods
[00:12:04] cluster again of the top 14 down moves 10
[00:12:07] are from two events, the GFC and pandemic.
[00:12:10] So what makes the June 11th 2020 sell off so interesting
[00:12:15] is how low the incoming realized Val was.
[00:12:19] Of the other top 13 moves,
[00:12:21] the average level of 10 day realized Val
[00:12:23] as of the day prior to the move was 61%.
[00:12:28] In the 10 days prior to June 11th, 2020,
[00:12:31] the S&P was realizing just 16.5%.
[00:12:35] Talk about lurching from low to high Val.
[00:12:38] Okay, my itch to revisit giant daily market moves
[00:12:42] has been scratched.
[00:12:43] Let's get back to today's setup.
[00:12:45] On the risk front, we can start with the Fab five,
[00:12:48] concentration, valuation, inflation, duration
[00:12:51] and correlation in words,
[00:12:53] the S&P is highly concentrated with a high PE,
[00:12:56] vulnerable to inflation, losses from duration
[00:13:00] and an unwelcome increase in correlation among stocks.
[00:13:03] Further, in the realm of unsavory outcomes,
[00:13:05] we would be remiss not to include geopolitical developments.
[00:13:09] It certainly feels dicey out there.
[00:13:11] Oh, and it is an election year in the good old USA.
[00:13:14] What are you doing on November 6th, by the way?
[00:13:17] In summary, option prices are really low
[00:13:20] because the motionless of indices like the S&P
[00:13:23] demands that be the case.
[00:13:25] Why pay for insurance on an asset
[00:13:27] that appears to present no risk of loss?
[00:13:29] There's no free lunch in the options market
[00:13:31] and the old adage says theta is the rent on gamma.
[00:13:35] That said, while the rent feels too high right now,
[00:13:38] the renter doesn't pay for the plumbing problem.
[00:13:41] We ought to be watchful for signs
[00:13:43] that the market's fixtures remain in good standing.
[00:13:45] A leak in one part of the house can lead
[00:13:47] to all kinds of knock-on effects in other parts.
[00:13:50] Hope you have a great week and catch you next time.
[00:13:53] You've been listening to the Alpha Exchange.
[00:13:56] If you've enjoyed the show, please do tell a friend.
[00:13:59] And before we leave,
[00:14:00] I wanted to invite you to drop us some feedback.
[00:14:02] As we aim to utilize these conversations
[00:14:04] to contribute to the investment community's
[00:14:06] understanding of risk, your input is valuable
[00:14:09] and provides direction on where we should focus.
[00:14:12] Please email us at feedback at alphaexchangepodcast.com.
[00:14:17] Thanks again and catch you next time.