My first Wall Street mentor, a grizzled sell-side Industrials analyst, would often tell me “message times repetition equals franchise”. Find a unique and investable insight, and then examine it from every angle. Highlight your findings until you’ve covered it completely. Then – but only then – move on to the next insight. Lather, rinse, repeat…
Since the middle of last month our message on US stocks has been “tax loss selling was an important cause of December’s decline, and January’s rise from those ashes was the result of a new tax year – not a sudden rekindling of animal spirits”. We’ve shown you how this has played out in 2019 sector performance (2018’s losers like Financials and Energy are 2019’s leadership) and in single stocks (again, big 2018 losers like GE up strongly in 2019).
One last bite of this apple today, using risk-pricing data from US listed options in the form of Implied Volatilities (IV) for various sectors and asset classes. We do this on a monthly basis, and the analysis here is similar to looking at the CBOE VIX “Fear” Index. When the IV of a given S&P sector or asset class like Small Caps rises, it is sending the same signal as when the VIX climbs; it shows traders are concerned about further declines. And when IVs fall, this shows declining levels of near term “fear”.
Since the peak of December’s selling frenzy was almost exactly a month ago, we have a convenient timeline to assess how much IVs have changed over the last 30 days, excluding today’s selloff. Looking at both the one month returns and changes in the “VIX of” a range of industries and asset classes, we find the following:
- Sectors that were disproportionately hurt by tax loss selling (Financials, Energy, large chunks of Consumer Discretionary) have seen their “VIXs” decline by more than the IVs for the S&P 500 over the last 30 days. The numbers here: declines of 38-39% over the last month versus 35% for the S&P 500.
What this means: there was nothing incrementally “wrong” with these groups in December 2018 aside from hosting some of the year’s biggest losers. Since the end of the 2018 tax year they have bounced back and (importantly) their “VIX” readings have declined as well.
- By contrast, consider Small Cap (S&P 600) versus Large Cap (S&P 500) US equities. The former has dramatically outperformed the latter in 2019 (7.7% vs. 5.0%). And yet the “VIX of” Small Caps is down less (-29% over the last month) than Large Caps (-35%).
What this means: even though Small Caps are off to a strong start in 2019, options market pricing betrays lingering concerns for this asset class. Volatility is typically inversely correlated to performance. The fact that Small Cap “VIX” isn’t dropping as quickly as that for Large Caps is a red flag.
- The “VIX of” US large cap Technology is only down 19% over the last month, much less than that 35% decline for the S&P 500. That’s odd, since Tech is still 20% of the index and should therefore trade closer to the market. And let’s not forget that Tech is actually underperforming YTD: +3.7% vs. +5.0% through today.
What this means: another red flag, showing that options markets remain more cautious on this most-important sector than the S&P 500 as a whole.
Lots of numbers here, so one qualitative message in conclusion: the US options market is pricing in a more cautious outlook than the equity tape has shown year-to-date. The tax loss sale explanation for December’s drop and January’s bounce ripples throughout this data. It still flashes yellow for Small Caps and large cap Tech, for example. As we mentioned in our Markets section, we believe this signals a tougher end to January than the easy ride we’ve had so far.