|The VIX According to a 20-Year-Old 'Seinfeld' Episode|
By Vince Foster AUG 13, 2012 7:49 AM
The foreshadowing from Cosmo Kramer and George Costanza is uncanny.
So you have this group of investors who are perceived to know what they are doing. You have the pump-and-dumpers who convince the unsuspecting small investor to jump into the speculation. Then you crash, the perma bears come out of hibernation screaming about the end of the world and conspiracy theories, small investors puke, the market recovers and the pump-and-dumpers are back on the scene yet again obnoxiously reminding us “I told you not to sell.” Sound familiar?
Today instead of measuring market sentiment at the coffee shop, the corner pub or front page of the Wall Street Journal investors are more and more coming to rely on the message of the VIX, the CBOE’s volatility index. Perhaps there is no more widely cited and watched market indicator of sentiment than the VIX. Though constantly being quoted by pundits, strategists, and on financial networks and websites, there is maybe also no more widely misunderstood market indicator. In fact it’s possible the obsession with recent extreme market volatility has ironically diminished the ability of the VIX to accurately gauge market sentiment.
The VIX reflects implied volatility (IV) premiums on various strikes of puts and calls in the current month and next month on the S&P 500 (^GSPC). Implied volatility isn’t actual volatility it’s the price component of an option over and above time value and intrinsic value. It therefore is supposed to reflect the market’s demand for volatility insurance.
Investors draw the simple conclusion that if the VIX is elevated the demand for insurance is high therefore sentiment is risk averse and conversely if it is falling there is little demand for protection therefore investors are complacent about risk. However, I think this interpretation of simply relying on the outright level of the VIX as an indicator of market volatility expectations is misguided in certain conditions.
Friday the VIX broke the psychologically 15 level closing at 14.74, falling to the lowest level since the March 16 low of 13.66 when the S&P 500 was approaching the highs of the year. Many investors are looking on the surface at this apparent collapse in implied volatility premiums and conclude the market sentiment has become too complacent. However if you look under the hood at what the VIX is actually measuring the S&P 500 option activity tells a different story.
For this exercise we will focus on the put option side of the VIX since it is generally downside price action that generates spikes in IV. For the August options expiring next week as you might expect the near the money strikes between 1400 and 1375 saw much of the volume on Friday with a total of 26,857 contracts in aggregate and IV ranging from 11% at 1400 to 13% at 1375. The 1375 strike seeing 9,112 contracts traded was the highest near the money volume strike followed by the 1400 with 7,267 contracts. However with the VIX falling, the single largest volume strike price on the board was 1300 with 14,392 contracts at 24% IV seeing 58% more volume than the next nearest strike at 1375.
Granted the gross dollar amount invested is much lower but on an annualized basis you would be talking about a massive move in a short period of time to get paid. Is that a market that is complacent about risk lifting crash puts with a week left to expiration? This is not just a phenomenon from last Friday. It has been the case seemingly on every market downtick into month expirations that you see large activity and open interest in far-out-of-the-money puts. The market is not prone to paying out lottery tickets but they continue to be bought in size month after month.
The way I read the formula, the VIX is misleading in this environment of volatility paranoia because the way it’s calculated does not effectively pick up extreme implied volatility (crash put) buying when it dominates activity. For one, the further out of the money the strike, the less contribution the option’s IV goes into the VIX.
In addition the VIX isn’t weighted for volume, only price and strike. Therefore, taking Friday’s trading as an example, despite seeing the most activity, the 1300 strike with 14,392 contracts at 24% IV provides very little contribution to the index. Without doing the actual math it’s quite possible the difference would be negligible, but it still would seem that a volume or dollar weight would more accurately reflect what IV premium investors are really buying.
The other aspect of the VIX that doesn’t reflect the current extreme sentiment is that the spot index doesn’t show the massive skew in the futures curve. For instance, on Friday the difference between the front and back months is over 10 points with the 2013 futures in the mid to high 20s. Contrast that with this same time in 2007 when arguably the systemic risk was extremely elevated; the VIX futures curve was inverted with futures trading at a discount to spot.
Earlier this week I commented via Twitter that when I watch the way the tape trades I see a stupid little kid that hasn't learned his lesson. Friday’s opening gap lower and reversal to close at the highs was just another example. It seems everyone wants to short this market but it won’t go down. I’m not suggesting either Costanza or Kramer is correct at these levels, but rather that the market is still in the process of flushing Seinfeld’s weak hands.
Going into August it seems the market has not been able to shake its post crisis crash paranoia. As posited a couple weeks ago in Bernanke’s Astonishingly Good Idea, the market appeared to be thinking it was August 2011. It’s like Kramer has continued with his melodramatic prophecies of gloom and doom and Seinfeld can’t take the thought of losing any more money.
It’s evident when you look at the positioning. According to ICI, for the week ended August 1 equity funds lost $6.9mm while fixed income funds gained $5.0mm. This is a continuation of the trend since 2009 where equity funds have seen $210b of net outflows while fixed income funds have seen $925b of net inflows.
It’s not just retail positioning. Large speculators have been short the S&P e-mini contract for the entire rally off last year’s low and just this past week finally covered to get flat. Last week the Stone McCarthy Portfolio Manager survey for week ended August 7 showed fixed income managers to have their highest Treasury allocations since September 2007 while having their lowest allocation to spread (risk) product since November 2007. This is truly remarkable considering where Treasury yields are and is further proof that fixed income PMs were also positioned for August 2011.
But after two weeks into August risk assets haven’t crashed and now the market is at the post crisis highs, looking like it wants to break out despite decelerating economic and earnings growth. Investors are hearing it from both Costanza and Kramer and the uncertainty with whether they will get suckered yet again gets more intense the longer the market rally lasts. It is a dangerous time for all investors, retail and professional alike, but if this market remains bid into the Labor Day weekend, there will be tremendous pressure to get exposed to risk into year end.
The foreshadowing from that episode over 20 years ago is uncanny. The 2008 financial crisis wasn’t about blowing up the credit bubble per se; it was about flushing the market hubris that had resulted from it. The conspiracy theory that the game is rigged and “you can’t win” is exactly what you would expect after consecutive bubble crashes, and it’s evident in how investors have approached their post crisis confirmation bias. That’s because while the price changes, the technology changes, and the media changes, sentiment doesn’t change.