Market Volatility – Advanced Training | Stock Talk Podcast

 

I am Chris Perras, Chief Investment Officer at Oak Harvest Financial Group and it’s the new year. First off, the team at Oak Harvest appreciates your support and we appreciate you tuning into our you-tube retirement planning videos as well as our weekly investment “News or Noise” and “Keeping you connected to you Money” podcasts.  If you like our content, we would welcome you referring our channels to your friends and family.

Since early November of last year, the investment team at Oak Harvest has been messaging that the first half of 2022 would not look like 2021. We have stated almost weekly that investors should expect actual realized volatility to rise, and regardless of whether Santa came to town during the second half of December, expectations for 2022, particularly the first half should be greatly tempered.

We released our first half 2022 outlook, on December 3rd under the title “Curb your Enthusiasm Yields to a Bull Market Buy”.  It can be found on our website at OakharvestFG.com or in video format on our You-Tube channel. Check it out. And we hope you become a YouTube subscriber to our content.

Sure enough, the first few weeks of 2022 have started out with a bang. And that’s not a New Year’s Eve champagne cork “bang” in a good way. For those hoping for a continuation of 2021’s calm market pattern, you are already having to face the reality of 2022, it won’t be as easy this year.

So, I wanted to go back to and readdress a topic we have discussed many times in the past, market volatility. And I wanted to go a little deeper into how our team looks at this factor versus the everyday comment you might hear on TV.  And I wanted to discuss how we might use it in determining whether we go fast or slowly in making incremental investment allocation changes for clients.  Let’s call this episode, Market volatility Advanced Training.

First off, viewers remember that the spot volatility indexes quoted most often on TV, the VIX Index for the S&P500 and the VXN Index for the NASDAQ 100 Index, are not tradeable.  They are both math calculations that reflect a market estimate, key word here is estimate, of future 30-day volatility.

I repeat; these often-quoted indexes are not directly tradeable. They are just math numbers based on short term implied options premium in the S&P500 or NasDaq 100. Because of this, the spot Vix by itself has little to no predictive ability in forecasting markets.

However, there are volatility instruments and tradeable tools that when combined with the level of the spot vix have been pretty good at helping to forecast, short of black swan events, when and about how much risk is in the overall markets.

Here is a graph of the volatility “term structure” of the overall S&P500 over the next 9 months taken on January 4/22.  You’ll see that the structure on that day was an upward sloping curve.  This “up and too the right” is the same shape and pattern that most financial futures markets have.  Things like interest rates or other things are shaped this way normally..  Why?  Largely because Insurance costs more, the farther out in the future you go.  This is called time premium.  Why does this additional cost grow larger the farther out in time you go?  Well, that’s because more uncertain things can happen the farther out in the future we look. More floods. More car wrecks, More accidents, both big and small.

Spot volatility, which I remind viewers is untradeable, was about 17 when we started the year.  This is while the actual cost of insuring against future volatility out 5 months into May was about 25.  This May insurance contract is tradeable.  You can buy and sell it.  There is a liquid market for it.  It is not just a math equation like the spot VIX.

 

Without getting too much in the weeds, here are three things we look at when our team speaks about “volatility” in helping with setting our forecasts.  1 – since the farther out, monthly volatility futures are freely tradeable on the CBOE exchange, they have real price discovery in them. Price discovery is important in that These futures prices are actual trades and transactions versus the spot VIX index which is just a mathematical formula.

Think of this as the difference between the quote you get from your real estate broker when you are looking at listing your house for sale, that would be the Spot vix in this analogy, versus the actual final selling price that you get months out in the future when the house sells and the bank transfers the money.  That would be the forward futures market.

The first quote on your house is a best guess based on comps, and the second is an actual transaction price.  And we all know that a lot of things and changes can happen between the real estate agent’s initial opinion and the final sales price months out in the future.

Because these futures contracts on volatility are real transactions, we can look at the longer term daily and weekly price charting trends on them to determine real supply and demand.  We look for trends, extremes, and resistance levels in forward volatility futures markets to estimate supply and demand for these contracts.  These pictures and charts can give us a great idea of when and at what level future market “anxiety” and worries lie.

The other two measurements we like to track with regard to volatility is 1 – the absolute “spread”, or difference between the spot index value and real pricing in future months and 2 – the % premium or discount that spot volatility is to future priced volatility.

 

Without getting into the minutia, with these measures and tools we were able to detect that the market reached short-term panic levels in very early December of last year when the Omicron covid variant was first discovered in South Africa.

Viewers, recall back then that the S&P500 sold off to around 4500, and the talk throughout much of the financial media was that at worst, the markets would crash again like March 2020 or at least, the December Santa Claus rally wouldn’t happen, and the markets would end the year poorly.

Viewers what happened to the S&P500 in December?  Exactly opposite those emotionally driven calls. This volatility  model, said relax and breath deep, neither of these negative forecasts were likely short term outcomes.  And what happened in December? The S&P closed the month up over 4% and ended the year near 4800.

 

Likewise, we can and do use this tool to aid us as an early warning indicator. Sometimes this type of indicator can help warn that investors are being too complacent and not fearful enough short term.  Such was the case a couple of times in 2021. It gave that reading once in the mid first quarter and then again in mid-summer.

What is this indicator saying currently? It’s saying the same thing it started to say in early November of last year. It’s making the case to be patient and go slow throughout the first few quarters of 2022.  It’s saying, unlike most of 2021, there will be plenty of buying opportunities, market rotations and fits and starts because of higher realized volatility throughout the first half of 2022.

We can blame the Federal Reserve. We can blame a Covid slowdown, or we can blame inflation concerns. The insurance indicator doesn’t care.  It just prices volatility. However, viewers, the good news is that right now, and yes this can change down the road and no it’s not the only thing that matters, but right now, this indicator is saying that by late summer, in front of the mid-term 2022 elections, and against the likely backdrop of a slower economy, the sun should shine again on the overall market, our 1st half concerns should pass, and we should exit 2022 on a high note of optimism for the economy and highs in the markets.

Is this a perfect indicator? No, not a chance, nothing is, black swans can hit at any time. That’s important to remember. However, this is a valuable tool that we use in our analysis, and we will continue to watch it as we take on the first half of 2022 in the markets for our clients.

From the whole team at Oak Harvest, thank you for your support and trust throughout 2021, and we hope we can continue to be your partner and provide you with value added service in 2022.

And Viewers, feel free to give us a call here to speak to one of our advisors.  Let us help you craft a financial plan that meets your retirement goals and needs first, and your greed’s second. Call us at (877) 896-0040 we are here to help you on your financial journey into and throughout your retirement years.