Today we will visit with 2 volatility/VIX related topics for “Data”.
#1: The CBOE VIX Term Structure, or what the market is expecting in terms of future volatility past just the next 30 days. Here are the VIX levels priced into futures markets by month out through October 2020, with Friday’s close of 22.05 noted in the green dotted line towards the bottom of the graph.
Three things pop out from this chart.
The obvious one is that VIX Futures out through October are much higher than Friday’s close, which at 22 is still higher than the 19.3 long run mean of the VIX back to 1990. Even though the next 30 days may be calm, in other words, this market thinks the next 8 months will not revert back to the long run mean.
As for why VIX Futures are saying that and why they seem to have picked the 29-30 level, check out this chart of VIX daily closes from the start of July 2020 to now. Note that as recently as late January 2021 the spot VIX was 37 and at no point has the VIX closed below its long run 19.3 average. The best we’ve seen is a 19.97 close on February 12th, 2021.
That brings us to our third point, and it’s very important: the VIX rightly treats past as prologue, and with good historical evidence in its corner. Volatility does not adhere to the famous “random walk” of stock prices. Instead, it clusters in high volatility periods like 1998 – 2003 and 2008 – 2012 and times of low volatility like 1992 – 1996, 2003 – 2007 and 2013 – 2018.
Takeaway: VIX spot and futures prices are tied to actual volatility, which history shows is sticky during and immediately after major economic shocks. As Jessica shows in her monthly 1 percent days analyses, it takes +1 year before US stock prices see even average (let alone below average) daily price churn. VIX Futures rationally reflect that reality even before you factor in current high equity valuations and/or the possibility of a Fed rate increase and higher long term interest rates.
#2: Not all volatility is created alike, so let’s compare the Russell 2000 Volatility Index to the S&P VIX Index. Small Caps should, of course, be more volatile given both their historical lack of profitability and more cyclical index composition relative to the S&P 500. And when we look at Thursday’s spot closes (FRED data is one day-delayed), we see that’s the case. The VIX closed that day at 22.49 and the Russell “VIX” closed at 32.65.
But here’s the thing: that 45 percent Russell volatility premium vs. the S&P is twice as wide as the 22 percent premium we saw in 2019. If we look back to the sort of relative volatility we saw between the Russell and S&P in February 2010, roughly analogous in terms of post-crisis lows after the Financial Crisis to 2020’s Pandemic Crisis, we find an even larger dichotomy. The premium in Feb 2010 was just 16 percent.
In short, this math shows that the Russell VIX is pricing in much more expected near-term volatility than the S&P because small caps are more levered to a US economic recovery. US small caps are flying without the parachute of Big Tech and with extra weight from cyclicals like Industrials (+7 point overweight relative to the S&P), Financials (+4 points) and Consumer Discretionary (+4 points ex-Amazon in the S&P).
Takeaway: this, in a nutshell, is why we can have days like Friday when the Russell rallied by 2.2 percent but the S&P essentially stood still (down 0.2 points). US Small Caps are – and will almost certainly remain – much more volatile than Large Caps both when compared to each other and when examined against historical norms. We have recommended easing up on Small Cap exposure in recent weeks because they’ve run so far, so fast. The analysis today shows why that’s happened and also serves as a good reminder that it will work in reverse should we hit a correction soon.