One of the biggest, if not THE biggest risk to the markets is the massive scale of bets against volatility. I’ve noted in several issues of our morning commentary that the markets are clearly showing no signs of fear, regardless of the potential geopolitical risks or the possibility that pro-business legislation might fail to pass. Instead, we see more and more funds betting that volatility will continue to trend lower. Some of these bets are done directly by short-selling VIX futures contracts, while others are done indirectly through the construction of portfolios where volatility risk is greatly underestimated, thus making these portfolios too heavily weighted in traditionally riskier assets like stocks. In fact, part of the reason for this is that volatility levels in many treasuries etfs are actually higher than that of equity index etfs such as SPY and DIA.
What all of this leads up to is a market that has essentially sustained itself through cannibalizing on itself, binging on cheap credit to finance trillions of dollars of stock buybacks, even as these same companies barely improved their productivity at all. With record low government bond yields globally, as well as dramatic contraction of volatility in risk assets such as stocks and equity options, the world’s investment funds are desperately seeking yield. This has led them to park money comfortably in the stock market, hoping that it continues to trend higher, as well as buying government debt during quantitative easing with the knowledge that the FOMC was providing all the buying pressure necessary to keep bond prices headed higher. And finally, this led to greater bets against volatility as fund managers began to feed into the depression of volatility by selling it more and more, which of course pushes the VIX and options premiums in general even lower.
But I expect that all of this will end soon since even if tax reform and significant deregulation occur, the markets will still have to come to terms with the impacts of a lack of government stimulus leaving companies to once again have to produce real growth, and increasing interest rates due to FOMC actions will make it much more difficult to buyback shares. As these things begin to unfold, we are likely to see a massive wave of shorts covering, as well as portfolios struggling to find liquidity as everyone rushes for the door. Let’s keep an eye on things for signs that the landscape is shifting.