Credit Suisse: Low U.S. stock volatility may be calm before storm

Relative calm in U.S. stock trading is an indication that the current bull market may become a bubble

Jun 12, 2015 @ 10:19 am

By Bloomberg News

Relative calm in U.S. stock trading is an indication that the current bull market may end with a bubble, according to Andrew Garthwaite, a global equity strategist at Credit Suisse Group AG.

In a report on Thursday, Mr. Garthwaite compared the Chicago Board Options Exchange Volatility Index for stocks, known as the VIX, and the Merrill Option Volatility Estimate, which tracks bonds and goes by the acronym MOVE. Both gauges are based on option prices.

The VIX fell 31% for the year through June 10, when the indicator closed at 13.22. During the same period, the MOVE climbed 30% to 89.76 as anticipation of interest-rate increases from the Federal Reserve sent bonds tumbling.

“Fear of losing money” in stocks is low enough by this yardstick to set the stage for higher prices, Mr. Garthwaite wrote. Declines in a ratio between the actual volatility of stocks and bonds this year point to the same conclusion, the London-based strategist wrote.

Mr. Garthwaite put the odds of an equity bubble at 60% to 70%. He cited central banks' reluctance to push rates higher, the effects of lower oil prices, the potential for more individual investors to move into equities and the likelihood that mergers and acquisitions will increase.

Most of the possible warning signs have yet to appear, Mr. Garthwaite wrote. He raised his year-end projection for the Standard & Poor's 500 Index to 2,200 from 2,170 and made an initial estimate for mid-2016 of 2,300.


Options traders have also speculated that while the turmoil that rocked bond and currency markets in past weeks has been mostly absent from equities, it won't be forever.

They're building hedges against equity swings to levels not seen in eight months, according to contracts tied to the benchmark gauge for U.S. stock volatility. Judging by the most popular options, many of them are bracing for disturbances in the next six days.

Placidity has ruled American equities for the better part of three years, a period in which the Standard & Poor's 500 Index has had zero declines of 10% or more. In June, concern about the Federal Reserve, whose policy makers meet next week, has sent Treasury yields to the highest since October and the dollar to levels not seen in two months.

“This is people getting ahead of the Fed, buying equity volatility because it has been low relative to rates and FX volatility,” said Pravit Chintawongvanich, a New York-based derivatives strategist at Macro Risk Advisors. “Equities have been in a very tight range lately and people feel like something has got to give.”


About 3.8 options protecting against a jump in the Chicago Board Options Exchange Volatility Index are held for each contract predicting a decline, Bloomberg data show.

Investors use VIX contracts as a tool to protect stock holdings from losses or to speculate on increases in market stress. The VIX, derived from options costs on the S&P 500, moves in the opposite direction of the equities benchmark about 80% of the time.

Five of the 10 most-owned VIX contracts are calls with strike prices as high as 23 expiring June 17, the last day of the U.S. central bank's June meeting. The VIX closed at 12.85 on Thursday.

As recently as March, traders were speculating that next week's gathering of Fed policy makers would be the occasion for the central bank's first interest-rate increase since 2006.

Odds for a move soon fell as U.S. gross domestic product contracted in the first quarter. As of Thursday, futures give a 55% probability for liftoff in September, up from 52% on June 8, according to data compiled by Bloomberg.

In the past week, reports showed employers added 280,000 jobs in May, the most in five months, while retail sales jumped 1.2%. Data released Tuesday showed a record number of help-wanted signs in April pushed job openings above hires for the first time ever.

“Investors seem to think that the Fed can't raise rates yet because the economy is too weak,” said Andrew Wilkinson, chief market analyst at Interactive Brokers in Greenwich, Conn. “If the Fed goes sooner than the current set of expectations, which I think will be justified, it will create some fallout. I don't think the equity market will react well.”


American equities' resiliency amid weakness in fixed-income and global currencies has puzzled investors. While measures of implied volatility on currencies and longer-dated Treasuries have climbed to their highest levels since at least the taper tantrum in 2013 this year, the VIX has hovered within a few points of its 2014 average as the stock market has powered to record highs relatively unfazed.

The last time speculators favored VIX calls over puts this much, their timing was prescient. In September, the VIX call-put ratio rose to 4.4, its highest level in seven years. A month later, the volatility gauge spiked to its highest in three years as the S&P 500 plunged 9.8%.


While the job market is improving, measures of inflation haven't come close to the Fed's targets, making it harder for policy makers to justify a rate increase in September or earlier, according to Max Breier, a senior equity derivatives trader at BMO Capital Markets Corp.

If the central bank changes its expectations for the first rate hike to later than September in its decision next week, the VIX could move back to 12, around its lows of the year, Mr. Breier wrote in a note Wednesday.

Investors have been loading up on portfolio insurance across asset classes all year and they've recently turned their attention to VIX options as other hedges on currencies, bonds and global stocks have become more expensive, according to Scott Maidel, an equity-derivatives portfolio manager at Russell Investments.

“There have been some cross-asset and cross-index volatility trading opportunities recently, with VIX relatively unaffected versus, say, V2X [Index] or rates volatility,” Mr. Maidel said.


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