Who the Vix Cares?
You know the world has gone mad when the probability of losses increases and yet investors double down! Month-to-date, the Vix has risen 48% from a low of 9.79 at the open in November 1st, to an intraday high of 14.43 on November 15, to eventually close up 17% month-to-date at 11.43 last Friday November 17th. Simultaneously, the JNIV (Nikkei 225 volatility index) rose 60% from 15.15 at the open on November 1st to an intra-day high of 24.22 on November 9, to eventually close up 32% month-to-date on Friday November 17th. Likewise, the VSTOXX (EU Stoxx 50 volatility index) rose 36% from a low of 12.00 at the open on November 1st, to an intra-day high of 16.29 on November 15, to eventually close up 23% on Friday November 17. During these volatility surges, all three underlying indices hit new highs (historical, two-decades, and two-year ones respectively). Markets screamed “higher risk”, and investors responded “no problem”.
The stock market is not the only place where new highs were seen. On November 15, Airbus signed its (and the aviation industry’s) biggest order in history, worth $49.5 billion. You might be forgiven to think this must have come from one of the highly profitable airlines in the industry, like Emirates, or Singapore Airlines, but this was an order for budget airlines! M&A activity has also reached new high in 2017 both in terms of valuation, number, and size of deals. Google “signs of irrational exuberance in 2017” and you will get a flurry of recent articles pointing to this or that indicator as having hit new highs recently.
This all begs the question, are investors in denial? To be fair, they can be excused for feeling this way. Volatility rose but is still historically low, so is correlation. Dispersion is high, and so is volume. Given this state of active management nirvana, investors are feeling pretty good right now and a volatility bump isn’t going to make them jump of this gravy train. To paraphrase Bryce Dallas Howard’s character Claire as the park operations manager in the movie Jurassic World, “Let’s be honest, no one’s impressed with a 20% volatility spike any more. Investors want them bigger, longer, and with more teeth”.
So how do we square this circle of continued investor optimism in the face of higher risk, and when will it end? Correlation is the key to both answers. Think of correlation as a stone thrown into a still pond. Watch the rings expand until they reach every corner of the market. Add an unforeseen risk event and red ink that begins as a trickle out of the gate, will grow into a stream throughout the day, and finally become a torrent. Correlation can turn a few pockets of weakness, into a whole market on the move, leaving you helpless, watching your losses multiply.
Investors are currently treating the mere notion of a market crash as exceptional; lightning from a clear sky. But, keep a close eye on correlation, both intra and inter market. Rising correlation will turn isolated losses into an extended family, and make a forgivable string of random bad luck resemble an unmitigated self-fulfilling disaster.
The catalyst could be geopolitical, financial, or natural crisis and trying to identify the driver of a correlation spike is a bit like looking for the Loch Ness monster – maybe there’s something there, maybe there isn’t – we’ll probably never know. Sometimes it’s fun pressuring yourself thinking about it though.