"Dust off the systematic hedging strategies, and get re-acquainted with the concept of tail-risk," is the ominous conclusion from MKM Partners' Jim Strugger's latest report. Despite every effort from central banks to maintain a low-volatility environment, the magnitude of the August 2015 'shock' not just for U.S. equities but across asset classes, was great enough for Strugger to conclude that a transition into a high-volatility regime had begun. Given the length of the economic cycle, bull market, and the rise in financial stress globally, Strugger warns a transition to a high-vol regime leaves ultimate damage in the &P 500 averaging 53%.
There have been seven distinct volatility regimes since the inception of the Chicago Board Options Exchange (CBOE) VXO implied volatility index in the mid-1980s, Strugger points out. The average duration of a volatility regime has lasted five years, with the most recent regime from late 2012 to August of 2015 lasting just 2.75 years.
Low volatility regimes have been positive for stocks. Periods such as 1991-1997, 2003-2007, 2013-current were historically a time of positive equity market gains, with low implied correlation, flat skew and stable upward-sloping term structure. On average, SPX monthly returns were positive 67% of the time, while spot VIX average 14, which appears a key resistance point today.
Since inception of VIX there have been five prior 40-magnitude VIX shocks, all during periods of structurally elevated volatility.. August was the trigger…
Crucially, U.S. Equities Are Not In a Vacuum…
A major gap has opened up between global financial stress and VIX which is unusual as they have historically tracked each other extremely closesly…
It’s a Global High-Vol Regime
GFSI measures risk via 41 sub-components across a range of asset classes and geographies. It inflected in earlier in 2015 actually preceding the shift in U.S. equity implied volatility…
In a worst case scenario, Strugger adds:
Implications are significant since the last two bear markets saw equities cascade lower for 1.5-2 years with ultimate damage in SPX averaging 53%
High volatility market environment calls for a different approach to tail risk
Contrast this with high volatility regimes. Strugger notes that since 1990 the two bear markets and every major equity market drawdown have occurred within high-volatility regimes, of which we have now entered. This points to what is currently a higher-risk environment with deeper equity market pullbacks. Is this a bear market? This “remains inconclusive from a volatility perspective,” Strugger says
“Even if a late-1990s type scenario unfolds and the bull market that began in March 2009 continues for another couple or few years, pullbacks relative to the 2012-2015 period will be sharper and equities will remain vulnerable to higher-magnitude shocks,” he wrote.
He notes fat tail risk and kurtosis can sometimes have an ugly correlation factor and advises institutional investors to “dust off the systematic hedging strategies, get re-acquainted with the concept of tail-risk” and consider volatility strategies that extract profits from elevated implied vol levels. This could include covered call and even put writing under certain circumstances.
“Our starting point for systematic hedging is to own 3-month index puts or put spreads partially financed by the sale of 1-2 month covered calls on individual stocks in the portfolio,” he advises, a strategy that resembles the CBOE S&P 500 95-110 Collar Index (CLL). Strugger also likes covering tail risk through VIX and volatility-linked ETPs (VXTH) in this environment.
Full report below:
Volatility Regime In Pictures – MKM
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