Right-tail risk swings to the left
For months, we have been writing about the unusual and unexpected low level of market risk. Risk for large-cap US stocks has skimmed historically low levels, and most other markets have seen risk far closer to historical lows than to highs. After the market drop on May 17, in the immortal words of Inspector Clouseau, “Not any more”.
VIX – which hit at least a 17-year low on May 8 -- jumped almost 50% to 15.59 from the close on May 16 to the close on May 17. (To be sure, VIX has reached far higher highs in the past, but the change was substantial.) At the same time, Axioma’s short-horizon fundamental risk forecast for the Russell 1000 climbed almost one full percentage point (from 6.68% to 7.60%, a 14% increase). Historically, that percentage-point increase in one day has only happened in a little more than 2% of the days since 2007, and a 14% increase is even more rare, occurring in only about 0.2% of days.
On January 23 of this year, when volatility was already unusually low, the Wall Street Journal’s James Mackintosh wrote about three possible reasons volatility might be so low. The first was that “markets are ignoring major uncertainties because they can’t properly assess them.” At that time trading volume was at a near-term low level, and it was certainly possible that investors didn’t know what to do, so they were not doing anything. Since then, however, volume has rebounded.
His third reason was that “shares don’t need a squeaky-clean leader to go up”, implying that the stock market is more related to the economy, and concerns about Trump’s “relationship with the truth” may have been seen as “fake news” by some investors. As long as the economic engine was chugging along, the market should follow, and a small ratcheting up of stock prices over time would also imply lower volatility. Currently there is no clear indication that the economy is about to falter, in fact economic data has signaled improvements recently.
I think his second explanation, however, is perhaps the most relevant to yesterday’s market decline and increase in volatility. Mackintosh noted that much of the uncertainty was “good uncertainty” – much of Trump’s proposed agenda – although uncertain – was seen as potentially providing a further boost to the economy (lower taxes, infrastructure investment, less regulation, etc.) The expected risk was still there, but it was skewed to the upside. What seems to have unfolded over the past several days is the view that his agenda was likely to come to a standstill. Take away the right side of the distribution and all of a sudden stocks are less of a sure bet.
Couple that with the old adage “sell in May and go away”, suggesting that investors typically take risk off the table as we head into the northern-hemisphere summer. With selling pressure, and more focus on the left tail, this is probably not the last day we see big moves in the market risk.