Bulls In A Glass House

The summer of 2022 has turned out to be a roller coaster ride for equity markets in what is notoriously a period of market calm. June started off flat coming off a short May rally from the lows in that month. Then halfway through June, the floor fell out for the market. We reached the S&P 500 low for 2022 (so far) right at the mid-point of June. Once that bottom was touched, the S&P 500 rallied over 14% to 4200 where the market sits as I write this piece. If you were to look at the S&P 500 price at the start of June and then leave for two months and come back on August 10th, you would have seen practically zero change. However, the underlying factors have significantly changed this summer.

Chart 1: The S&P 500 Resided In This Bowl All Summer (Source: Koyfin)

Sprinkled throughout this summer were back-to-back 75 BPS rate hikes (multi-decade highs for the Fed), 40-year high inflation prints, a second GDP contraction measurement, and Chinese military exercises after an American politician landed in Taiwan. Also, let’s not forget that even though gasoline prices have come down since their highs in June, the supply problem is only patch worked as the United States continues to drain the Strategic Petroleum Reserve to decade lows when Geo-Political tensions are at decade highs, and Russia has not backed down in the conflict with Ukraine. Equity prices seem unfazed with this information as they grind higher from the June lows. There is no fear out in the market right now. It is as if so much bad news hit the tape this year that a catastrophic event would only mildly faze us. This has been shown in the VIX as well, which on August 10th dropped under 20 for the first time since April 2022. A VIX reading of 20 is near the long-term average in a choppy index. However, nothing about this year, especially recent data, would make you think the market’s volatility reading should be under the long run average. In a past post, I painted the VIX to be like a spring. When a spring is compressed, it shrinks down in height. All the while the spring produces potential energy, waiting for the pressure to be lifted. Once that pressure is removed, springs release a burst of energy and all the potential energy built transforms into kinetic energy.

Chart 2: VIX Index August 2022 YTD (Source: Koyfin)

Looking at Chart 2, you can see the sliver of 2022 the VIX spent under 20. A VIX under 20 is simply building potential energy, waiting for the release valve to open. As volatility sellers continue to compress this index, market participants become complacent with the low volatility in the market. Kris Sidial from the Ambrus Group gave a great explanation of the structural reasons for the VIX suppression we have seen recently here. This “low volatility” complacency can quickly turn into major losses as market participants take off their hedges each day the S&P 500 rallies higher, leaving portfolios more exposed. In fact, the environment we are in today where volatility is suppressed and there is high uncertainty in the near future is a perfect set up for adding cheap tail risk exposure. This is a contrarian position among market participants, which provides a good risk/reward profile.

The last piece of this analysis involves the heavy option market volume that has occurred in recent years and the changes this volume has had on market moves. Equity option trading volume exploded during 2020 and 2021, specifically with call options as market participants used the leverage options provide for short term bets on stock prices. This trend significantly increased market maker impact in financial markets. Here is an example of what I mean: when a market maker sells a call option to the purchasing party, the market maker is effectively short a call option equal to being short the underlying stock. The market maker now must go out into the open market and hedge the short option position with buying the underlying asset to be neutral. This hedging practice was what Meme stock buyers exploited when buying call options on heavily shorted stocks because they knew the market makers had to go out and buy the underlying stocks to hedge their books. The result was the price of the underlying stock increased significantly and more option buyers flooded in to repeat the process. The reverse of the above example can also happen where market makers have to sell more stock to hedge their book causing asset prices to move down in price even more. Done at scale, market maker activity can move financial markets aggressively in either direction. This was seen in the spring of 2020 when financial markets crashed and rebounded in a matter of a few weeks as option purchases mixed with market maker hedging exacerbated market moves.

Market makers can also suppress volatility with their hedging. This phenomenon can have major impacts on markets that seem to quickly mean-revert. For investors, the mean-reversion moves made “buy-the-dip” strategies so effective, especially in 2021. I mention the market makers because their prevalence in markets cannot be ignored when looking at volatility. If market makers are long gamma, the volatility seen in markets is suppressed. However, if market makers are short gamma, the volatility in markets is exacerbated. Market makers are net long gamma right now, which is another reason why volatility is suppressed, but this has been a recent shift in exposure. If markets were to move sharply lower though, the market makers could easily move from being long gamma to short gamma again. Then volatility would go back to levels seen earlier this year.

As we enter into the fall (a notoriously volatile time of the year for markets), market participants should stay alert to the road ahead. This fall in particular has great uncertainty: Mid-Term Election results, the end to the Strategic Petroleum Reserve release of 1 million barrels of oil per day, Fed rate hike decisions, more inflation data, and more GDP data. Also, there are significant idiosyncratic risks beneath the surface at a global economic level as well, specifically in Europe and Canada. I will dive into these in more detail in a future post. Finally, the gamma exposure of market makers is another piece of crucial information to monitor as the year progresses.

At the end of the day, jamming a spring down further is a harder task than letting it go. A VIX under 20 only has so much room to go down before it reverses course.

Don’t Fight Convexity

Disclosure: Funds I Control Are Long Various Volatility Products

Note: This post consists of high level commentary on research conducted by Tetelestai Capital, LLC into volatility of the S&P 500. Though compelling, your own research should always be done before investing into any security. This post should not be viewed as investment advice. If you have any questions about the research Tetelestai Capital conducts, please reach out through the website for more information.