The Volatility Bubble – Part II
A few months ago I communicated that investors are becoming ever more complacent in the market, causing extreme speculation on short volatility.
The VIX has fluctuated up and down which has given great trades on both the long and short side. Nevertheless, the VIX has trended even further down and is now flirting with all-time record lows.
Investors have a natural inclination to become comfortable with slow, steady upward moves. A year ago many people thought Dow 18k was overvalued. Today you will be hard-pressed to find someone who still thinks that!
Nothing much has changed since last year. Earnings have improved somewhat and are now around late-2015 levels.
We have a pro-business administration, which is great for the economy, however Congress has shown they have trouble agreeing on the simplest of things (due to politics). One side of Congress is trying to push legislature through as soon as possible while the other is trying to subvert – with both sides making their decisions based on the upcoming 2018 elections.
Things aren’t going to change at the pace that many investors expect. It takes a while to put together tax reforms, for the cuts to be implemented, then a while for the effects to show up in tangible earnings. If people do not see these positive effects soon, the 2018 elections will sway the other direction and the administration will lose some of its control over the House and Senate – making it even harder to push through legislation.
Despite all of this, investors are becoming more complacent as time passes because they have gotten accustomed to the market’s valuation. Remember how I said Dow 18k may have been considered overvalued a year ago? Well today it may be Dow 22k, and anything under 21k would be considered a great buying opportunity.
The financial media justifies the current market valuation because certain companies have been making or beating their earnings guidance.
However simply beating earnings does not mean that the market is a great buying opportunity. The market can trade at 500 P/E multiples and still beat earnings estimates!
This shortsighted view of the market is how bubbles form – people convince themselves that the market “should” be at these valuation levels.
This relates to the “boiling frog” analogy: throw a frog in boiling water and it’ll quickly hop out. Place a frog in warm water and slightly raise the temperature, and it’ll stay there until being boiled.
It is easy for investors to look in hindsight at the dot-com and housing bubbles and think they could have predicted the subsequent crashes based on their knowledge today. However most people do not realize that things weren’t that different back then.
The financial media and investors were justifying the high market valuation in 1999, just as they are doing now. And 18 years from now investors will look back onto 2017 and say the same thing – they could have easily seen the market was overvalued in 2017, and they definitely won’t make that mistake in 2035. The cycle continues…
The long volatility ETNs are nearly 100% shorted, with the VIX at record-lows.
If and when the market experiences a hiccup – whether it be companies missing earnings, the Fed tightening faster than the economy can sustain, a geopolitical event (ex. North Korea) – there will be a massive volatility short-squeeze and a huge number of volatility speculators will lose money.
I do believe shorting volatility is generally a wise decision depending on the individual’s particular circumstances, however shorting volatility at this moment is no wiser than buying technology stocks during the dot-com bubble.