zondag 28 mei 2017

Bank Of America: "These Markets Are Very Weird"

In the latest delightful note from serious "non-tinfoil" sources confirming just how broken the market has become (and how right all those who said central banking and HFT would eventually break it), Bank of America's vol expert Benjamin Bowler and team just released a report titled with the self-explanatory "While not obvious on the surface, these markets are very weird." Actually, for anyone who has traded these markets in the "before" and "after" central planning phases, it is all too obvious just how weird the markets have become. For the benefit of all other 17-year-old hedge fund managers and 24-year-old math PhD quants, what BofA finds striking is that "last week’s sudden shock to US equities, and rapid rebound, yet again demonstrated the historically unusual tendency for markets to jump quickly from calm to stress and back (“fragility”)." BofA's peeve with the market's "Buy-The-Dip" reflex is hardly new, and was first pointed out by Bowler in mid-March, when the strategist lamented that "perversely, US equity sell-offs have seemingly become embraced as alpha (buy-the-dip) opportunities instead of being feared as bona fide risk-off events, as the central bank put has become a self-fulfilling prophecy"...


Two months later, it's more of the same as BofA notes that the -1.8% drop in the S&P 500 on 17-May was a five standard deviation (5-sigma) event vs. trailing volatility, the third such outsized drawdown in stocks in less than a year, but only the 18th since 1928. What is more surprising is that the sudden air pocket was immediately followed by the second-fastest retracement of a 5-sigma drop since 1928, illustrating the power of today’s “buy the dip” mindset. And while some, such as Deutsche Bank most recently, have called the market's apparent invincibility a function of the "Trump put" which has allegedly replaced the "Fed put", to BofA there is something bigger in play: The fact it occurred in the face of risks to Trump’s policy agenda illustrates that today’s Pavlov buy the dip is not a Trump put, but something more powerful. The sudden jolt to US equities also catalysed record spikes in vol of vol and SPX skew last week.
For those concerned that Trump’s policy agenda may be diluted, delayed, or possibly defeated in the coming months and catalyse a grind lower in stocks, we like leveraging steep skew via SPX put spreads and down & out puts as hedges. Is that really the weirdest thing about the market? Hardly: we have spent the better part of the past 8 years showing and documenting precisely that, bizarre market outlier events, and in this particular case, the market's insta-rebound response has been repeatedly documented by JPM's Marco Kolanovic, who has shown how progressively shorter the half-life of every selloff has become. However, we find it useful that more "professionals" not only observe but quietly complain against what is clearly an artifact of a broken market structure: after all that may be the only way something ever changes. Here are some additional observations from BofA, which is clearly fascinated with the "Third 5-sigma SPX drawdown followed by 2nd-fastest retracement in history" Last Wednesday’s (17-May) sudden shock to US equities, and the ensuing rapid rebound, provides the latest illustration of the capacity for markets to jump extraordinarily quickly from states of calm to stress and back, a dynamic we called market “fragility” in our 2016 Outlook. Consider that:
# Prior to the -1.8% drawdown in the S&P 500 on 17-May, the realized volatility of the S&P had been 5.7% (36bps daily vol).1 Hence the equity decline, while not large nominally, was in fact a five standard deviation (5-sigma) event (1.8% / 0.36%) when accounting for how low volatility was prior to the shock (Chart 7).
# The last such 5-sigma event occurred on 9-Sep-16, when stocks were jolted out of their summer lull by weakness in bond markets, and prior to that on 24-Jun-16 following the Brexit vote (Chart 7). In other words, the past 229 trading days have delivered three 5-sigma drawdowns in the S&P 500 (1.3% frequency of occurrence). In contrast, the prior 22,222 trading days (i.e., since Jan 1928) witnessed only 15 such drawdowns – a frequency of 0.07%, or 19x less frequent.
# Perhaps even more remarkable than the capacity for US equities to jump from calm to stress today is their ability to revert astoundingly quickly back to a state of calm. Chart 8 shows that in the three trading days since 17-May, the S&P 500 has recouped 85% of its 1.8% decline. This is the second-fastest retracement of a 5-sigma drawdown in the history of the S&P 500 and not dissimilar from the speed of recovery seen both after Brexit and in Sep-16.
# These records underscore our view that market shocks have come to be viewed by investors as alpha opportunities rather than marking the onset of rising uncertainty. Initially, a clearly visible and high strike Fed put taught the market to “buy the dip”; now, however, this behaviour has simply become a learned response function...


Sudden jolt to US equities led to record rise in vol of vol and SPX skew In equity volatility, the effects of the outsized drop in US equities on 17-May were profoundly felt in skew and vol of vol. VVIX, which measures the implied volatility of 1M VIX options, experienced its largest one day rise (34.7 points) since Feb-07 (not coincidentally another 5-sigma shock to US equities). S&P 500 3M implied volatility skew experienced the largest rise in stress among GFSI’s 43 sub-components by a factor of nearly 2x (Chart 9) and a 99.8th percentile rise relative to its own history since 2000 (Chart 10). While S&P skew has receded from the extremes reached on 17-May, it remains historically elevated, particularly on the put side where the ratio of 10-delta to 35-delta SPX 3M put premiums (as one example) reached a 10yr+ high on 17-May and ended last week in the 97th percentile based on daily data since May-07 (Chart 11)...