A volatility storm is buffeting markets. When will it clear?
Summary
Though much of the stock selloff is likely caused by a reversal in speculative trades, rather than deeper problems, the market won’t immediately go back to normal.This week’s stock-market roller coaster appears to be driven by a reversal in speculative trades, rather than the popping of a bubble or an omen of economic disaster. But that doesn’t mean we are in the clear.
Japan’s Nikkei 225 index rose 10.2% Tuesday, undoing more than half the damage caused on Monday, when it recorded its worst one-day drop since the 1987 flash crash. Stocks also rose in European morning trading, albeit much less dramatically.
The lightning-fast rebound mirrors the pattern observed Monday in the Cboe Volatility Index, or Vix—a measure of the expected volatility of the S&P 500, known as Wall Street’s “fear gauge." In the early morning, the Vix hit 65.73, the third highest mark since records started in 1992, following the 2008 global financial crisis and the 2020 Covid-19 crash. By the market close, however, the Vix had fallen to 38.57, closer to a regular bad day.
The difference between the index’s intraday high and close was the largest ever. The Vix’s peak was also a record when compared with the maximum level of actual volatility recorded by the S&P 500 during the day. The rout has been far more virulent among the options contracts that form the basis for the Vix than among the actual S&P 500 stocks that they track.
Such a decoupling suggests that options are leading the rest of the market: The tail is wagging the dog.
In periods of calm, investors get rewarded for betting against volatility through products laced with options. Back in 2017, it was retail tracker vehicles that were explicitly “short volatility." In the run-up to this current rout, a proliferation of structured products likely contributed to the market calm. In each case, banks take the other side of the trade and then hedge the risk in a way that suppresses volatility.
Eventually, bad news scares investors and volatility skyrockets. When traders rush to cover losses, they sell the most overbought assets, which in turn generates volatility. Automatic sell orders, as well as momentum and “risk parity" strategies, further fuel the feedback loop.
Options aren’t behind all volatility suppression. In the case of the Japanese yen, the assumption that the Bank of Japan would keep borrowing costs permanently low fueled a mammoth “carry trade." For years, investors borrowed at rock-bottom Japanese rates to buy higher-yielding assets, including U.S. tech stocks. When officials in Tokyo decided last week to tighten monetary policy for the first time in 17 years, a global whiplash ensued.
A crash driven by complex market undercurrents is the most benign kind of crash because it doesn’t reflect a deeper economic problem. “Black Monday" in 1987 ended up being a blip, and even the 1998 Russian crisis that took down Long-Term Capital Management didn’t keep equities down for long.
The S&P 500 has fallen 8.5% from its record high in just 14 days. An analysis by Bespoke Investment Group shows that such rapid selloffs are rare, but tend to be followed by strongly positive returns in the subsequent weeks and months. The Covid selloff in 2020 was an exception, though in time the market did stage a powerful rebound.
Still, the road ahead could be bumpy. Volatility traders often stress that it takes time to clear bad trades from the system, and the historical record bears this out. On average, a volatility spike leads to four or five weeks of patchy equity trading, and a higher trading range for the Vix. The “volpocalypse" rout in February 2018, when the short-volatility retail trackers came unstuck, was followed by a short-lived rebound and then a second correction in mid-March.
Figures from the Commodity Futures Trading Commission suggest that there may yet be bets against the Vix waiting to unwind. Net hedge fund positioning against the yen is even more stretched, amounting to about $6 billion by the end of last week, though this is still a big fall from $14 billion in July. To cover against losses from the unraveling Japanese carry trade, investors tend to buy the yen, which is up 11% against the U.S. dollar since the end of June.
For most investors, weathering the initial flash crash will be relatively easy, especially with Asian and European markets already appearing to return to normal on Tuesday. Keeping a cool head if a second wave hits might be harder.
Write to Jon Sindreu at jon.sindreu@wsj.com
