The Wild Ride May Be Over: Volatility Normalizes for the First Time in 2016

Have cooler heads finally prevailed?

Investors Flock to Safety as Volatility Grips Markets

Calm may have settled on financial markets for the first time in 2016.

“Investors underestimate the resilience of equities, and their ability to sustain additional gains at key turning points,” wrote Fundstrat Global Advisors LLC Managing Partner Thomas Lee. “This week, several developments took place across markets which we expect to result in investors becoming significantly more willing to own equities.”

As such, the odds of a double-digit jump for equities in short order has been further bolstered, according to Lee.

This year has been marked by widespread risk aversion and elevated cross-asset correlations, with concerns that the “central bank put” had vanished and monetary policy had become largely impotent. Lee, however, sees a plethora of signs that suggest this period of angst is over. The developments he says are positive for risk assets include an improvement in sentiment from depressed levels, a pickup in short interest, an increase in the number of stocks trading above their 200-day moving average, and—perhaps most important—a return to a more normal volatility regime.

This week, “the VIX fell below 20 AND the VIX term structure (4M less 1M) normalized for the first time in 2016,” wrote Lee, who noted a particularly decisive decline in the spot VIX on Thursday:

Fundstrat/Bloomberg

The CBOE Volatility Index (commonly known as the VIX) tracks the implied volatility of the Standard & Poor’s 500-stock index over the next month based on at-the-money options prices. It tends to move in the opposite direction as the S&P 500, and a spot level of 20 is considered an important psychological threshold at which implied volatility is particularly high.

The term structure of VIX futures—like sovereign-debt yields or commodity futures—tends to slope upward in normal times. A downward-sloping VIX curve suggests implied volatility is especially elevated: Traders are paying more for short-term than for longer-term protection.

“When the VIX recovers from an ‘inverted structure’ (1M higher vs. 4M), this has marked tradeable lows since 2004,” Lee concluded. “Most recently, this took place in 10/15 and the S&P 500 rallied 12 percent in the following month.”

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