The Stealth Rally in Volatility

While December 2013 may seem like a pretty quiet end to a strong year for U.S. stocks, the VIX is actually on a tear thus far through the month.  It closed out November at 13.70, and is up some 17% since then to close at 16.03 today.  Against the average decline of 3.1% we noted, that’s a visible bump.  And considering that the typical move from now through year end is another 1.1% increase, it looks like the rally in expected volatility may be around to ring in the New Year.

Is volatility on the rise? You’d never know it unless you were looking at the Vix itself – the market commentary of late is quite complacent with only tomorrow’s Fed meeting standing in our way of closing out the year quietly.

And yet vol is having a big month, unbeknownst to most.

Here’s Nicholas Colas, chief market strategist at ConvergEx Group, with his take on what we could be seeing:

The historically anomalous move for the VIX in December 2013 forces one question to the fore: is this the beginning of a return to more “Normal” volatility, or just some year-end insurance buying by active managers looking to lock in their gains?  There are good arguments for both camps:

We’ve experienced a remarkably quiet year for volatility in U.S. stock markets, and even at its current reading of 16 the CBOE VIX Index is still well below its long run average of 20.  We chalk that up to the Federal Reserve’s interest rate and Quantitative Easing policies.  Aside from a few weeks of doubt in June, these have been the market’s best friend and constant companion throughout 2013.

How long will the Federal Reserve and equity markets be able to hold onto their friendship?  That’s the question for 2014, and it makes sense that options investors would want to hedge their portfolios ahead of Wednesday’s FOMC meeting as well as those in Q1 2014.  It has been a great run from the lows in March 2009, equity valuations are fair (if not a little full), economic fundamentals are only slowly improving (and about time, too) and corporations are not yet fully out of their foxholes and hiring.

Of course you’d start to hedge with options – makes all the sense in the world.

At the same time, there is a strong correlation between the year-to-date performance for the sectors and asset classes in our study and the recent moves in their Implied Vols.  Options players aren’t bidding up the VIX for gold or silver because, well, who cares about precious metals these days?  Same for corporate bonds for that matter.

Given this relationship between performance and Implied Vol, it is equally easy to write off this year-end rally in the “VIX of” winning equity sectors and market caps to risk aversion in the final days of the year.

You’ve had a great year – of course you’d hedge out your risk.  Makes all the sense in the world.

The truth is BOTH these explanations resonate.  Volatility got way too cheap – and complacency too high – in 2013.  There’s a great temptation in market commentary to call everything either a “Bubble” or a “Generational low”.  Life rarely hit such extremes, so I am reluctant to hitch my wagon to either train too often.  Still, reversion to the mean – in this case “20” on the VIX – is a powerful force in life and markets.  As old time TV detective Baretta used to say, “You can take that to the bank.”

How many players are positioned for a return of volatility? How many are expecting it or even remember what it felt like? As one trader mentioned this morning, we’ve had quite the free ride in 2013. As you can see in the embedded chart below, we’ve not spent a single moment beneath the 200-day moving average thus far this year. That hasn’t happened even once since 1995.

It would be hard to believe that the new year would bring us just more of the same.

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