Second Half Outlook Breakdown – Part Three: Volatility is Overstated

Join us for Part 3 in our breakdown of our 2021 Second Half Market Outlook! In this episode, we discuss Volatility, and examine current trends and levels in light of historical trends and data. In our opinion: the data shows concerns about volatility are overstated and current levels add to an existing bullish backdrop for higher-than-most expect stock market moves in the 2nd half of the year.

Chris Perras: Hey, happy Friday. I’m Chris Perras, Chief Investment Officer at Oak Harvest Financial Group. We are an investment management and financial advisor here in Houston, Texas, and welcome to our July 9th Stock Talk podcast: Keeping you connected to your money. Well, last week we released the second of our multi-part series in our second half 2021 outlook entitled Let the Good Times Roll. This forecast is being broken down into multiple segments with each segment trying to address a different topic currently on investor’s mind. The third in this series, which after this week should be particularly interesting and timely to our listeners is titled Market Volatility. It’s overstated.

Moreover, volatility should be expected during pre-earnings reporting and stock buyback blackout window, dead zone time period like we are now in. In the summertime, well, that makes this period even more nerve-wracking for most investors. I say that this topic is probably timely because just this week, well, more precisely Wednesday night into Thursday morning, we saw a classic case of a spike in volatility. All sorts of reasons were thrown around yesterday as to why this happened. Some of the excuses given were increased COVID cases caused by the Delta variant, Japan announcing a Countrywide emergency again due to COVID, and shutting out spectators for the upcoming summer Olympics.

The third excuse I heard was China announcing some monetary easing measures due to their slower growth. I’m not going to try to claim I know the exact trigger for this sell-off, maybe the prime brokers or margin clerks know, but what I can say with high conviction is the selling we saw was largely forced de-levering by big leverage traders all positioned in the same trades. Traders that we talked about at the beginning of the second quarter when we saw bond yields and inflation peak long before other market commentators. What were these stale trades everyone was sitting in? They were long value, long cyclical, long commodities, long small caps, and short long treasury bonds. In short, the dollar.

Well, so much once again for conventional wisdom working in a quarter. We know how that worked out. As for forced de-levering this holiday-shortened week, why do I say that? Well, because as we’ve discussed in the past, treasury bond market volatility as measured by the move index has led equity market sell-offs the past few years. Well, since June 10th, that’s roughly one month ago, treasury bond market volatility has been increasing slowly and steadily. Well, that changed early this week with a sharp move down and long-term treasury yields causing a spike and bond fall.

There’s a lot of smack being thrown around on TV channels suddenly about the markets not wanting lower long-term interest rates. These same strategists were saying that stock markets would hate higher interest rates when they were above 1.7% and 5% a few months ago. Well, listeners, which is it? Are higher rates bad or lower rates bad? The market likes low long-term interest rates. However, it craves higher slightly trending higher long-term rates as proof the economy is growing. That’s Goldilocks for the overall stock market because groups besides large-cap technology stocks work. As technicians say, market breath expands. It isn’t the so-called stock pickers market that everyone talks about, virtually everything works.

Pick an excuse, any excuse, but the telltale signs of force selling were rampant Thursday. The first tell, the selling started in the overnight session late Wednesday night, early Thursday morning when Japan and then Europe opened for trading. Your pension plan and your 401(k) provider doesn’t trade size in the overnight session. Why? There isn’t enough liquidity for it. Second, the market went up straight down in your linear fashion until mid-morning when the European markets closed. The straight-down linear fashion is another giveaway for margin selling as these large institutional traders just use trading algorithms that VWOP, that’s an acronym for volume-weighted average price selling.

They pretty much sell indiscriminately based on the amount of stock that’s trading. They don’t put stop losses on it, they don’t put price targets on it, they just sell based on the volume. Third, every major U.S stock index I looked at was down almost the exact same percentage at the exact same time on their lows. The S&P 500 was down the same percentage as the Dow Jones. It was down the same percentage as the Nasdaq and the small caps were down the same percentage of all of those. That dynamic reeks of indiscriminate selling.

Finally, the first group to bounce yesterday was small-cap growth stocks. This is the most illiquid and inherently volatile asset class in the market. Near the lows of any market move, this is the group that usually drops first as big investors stop selling them first and they turn around and they sell what they can instead of what they want to. Since mid-second quarter of 2020, the investment team at Oak Harvest had tried to keep our investors and prospects focused first and foremost on the data and what is driving overall markets higher instead of the hourly, daily, or even week-to-week or month-to-month moves.

By doing so, we’ve tried to keep investors away from the still [unintelligible 00:05:48]. This time it’s different and what we’re seeing is unprecedented terms. We’ve tried to present the real-time data as much as possible to show that the financial markets continue upon a relatively normal recovery path since the second quarter of 2020. At least a normal path of recovery since this cycle began in early 2009 over 12 years ago. This includes a very normal path of an overall trend in declining, not rising volatility. Turn on the TV and one would be led to believe by the constant discord on CNBC amongst other strategists and economists that volatility has been extraordinary.

It’s been unprecedented. It hasn’t been. As one can see from the daily chart for the past three years, post events like the COVID virus last March, the general trend in future implied volatility over the next two years has been down not up. Yes, you heard that right. Overall, implied volatility has trended down, not up, the last 15 months. There’ve been bouts of short-term jumps in both spot market volatility and future implied volatility. However, the general trend and the channel remains down into the lower right, not higher and up. Looking at the longer-term weekly chart for the past 10 years in future implied volatility, one will see that it is normal for out months volatility to decline to a level of about 14.

The current measure that I’m looking at stands at 22. It’s currently standing at over 50% higher than its normal cycle lows the last 10 years. Second, we see the trend in actual realized volatility. Listeners, remember this is the volatility we actually see and feel on our screen on a day-to-day basis. Where does realized volatility stand as a measure? Well, I look at something called a RVOL Index on Bloomberg. Where does it sit? It sits around eight and a half to nine. To put this into perspective, the historical lows in this measure are half that level. They’re four and a half to five. That happened during the fourth quarter of 2017 only four years ago.

I like to compare the ratio of implied volatility to actual realized volatility and compare the value and trend. Why do I do this? I like to think about it as a measure of an insurance premium. Realized volatility is the actual daily volatility of shareholder experience. It’s what you see on TV. It’s what you feel if you open your portfolio every day. Its price moves day-to-day and week-to-week. Meanwhile, future implied volatility is a measure of insurance premium. Investors are paying to hedge portfolios out in the future. Looking at these two metrics in unison and the trend of the metrics, I get a sense of whether options to protect themselves against a market drop look expensive or cheap versus the current cycle. Once again, I look at trend as much as level. What do I see now? What do I see into the second half?

I continue to see the same thing we saw last year that fear of extreme downside moves in the markets is being priced much higher than it should be. This is entirely normal, as there has been almost always a recency bias in investor’s mind for up to two years after events like 911, the great financial crisis, and other traumatic events. I believe that the recency bias that investors experienced last year is causing them to vastly overpay to ensure their portfolios and this, in turn, should provide additional upside support for the S&P 500 in the second half of this year. What happened mid-week in our markets in terms of volatility and price action is what happens in bull markets.

The markets are particularly vulnerable to this during the summer, in the dead zone periods like we are now because most companies can’t buy back their stocks. We get periodic short-term bouts of volatility. But overall, volatility and expectations for future volatility should remain in general downtrends for the rest of 2021 and early 2022. It’s summer and as far as the team at Oak Harvest is concerned, so far it’s a very normal one at that. At Oak Harvest, we’re a comprehensive wealth management financial planning advisor located right here in Houston, Texas. Give us a call to speak to an advisor. Our phone number here in Houston, Texas, 281-822-1350. We’re here to help you on your financial journey with a customized retirement planning. God bless and have a great weekend.

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