Could an iconic stock market fear gauge be lying to us?
It would appear so, according to a startling Bloomberg article published on Monday.
In Lynn Thomasson’s piece, she notes that negative S&P 500 options skew – the difference between the prices of options betting on a fall in the market (puts) and those that would profit from a rise (calls) – has reached a 22-month record. “Traders sought protection as shares rallied for six weeks,” Thomasson notes.
Consider the role of these put options and you can see what the fuss is about. Put options are insurance contracts taken out by mindful traders. They buy these puts when they suspect stock prices will fall. The record rise in skew therefore shows you just how worried these traders are. The premium, or price, of those downside put options is relatively higher than it has been since June 2008, as you can see from the chart below which shows the skew ratio.
The steady rise of ‘downside insurance premiums’
In short, it’s a lot more expensive to bet on a crash than it is to bet on a continuing rally. That’s actually the norm. Skew, in stocks, tends to be negative. But it’s very rarely at the levels we’re seeing now. The last time it was at these levels, stocks went on to fall 25%. So you can appreciate the significance.
We have spotted a discrepancy though…
If traders are paying over the odds for downside protection, why is the Vix trading so cheaply?
The S&P 500 volatility index, known as the Vix, is perceived as the fear gauge du jour. To quote the CBOE Futures Exchange, “A low Vix indicates complacency.” And the Vix (which you can read more about here: Two ways to play volatility) is at a 23-month low.
You can see from the chart below, the price of the Vix is nearing 15. At this annualised rate of decline, the Vix could hit its all-time low of 9.31 in just ten months!
The precipitous fall of the Vix
To recap, the Vix is low and falling, implying “complacency” among stock traders, and skew is high and rising, implying relative panic among stock traders.
How can these two things be happening at the same time?
One of these two indicators is misleading us all. On the plus side, earnings season has been nothing short of glorious so far. JP Morgan, UPS and more have reported consensus-beating quarterly profits. On the downside, this good news looks priced into the market, which hasn’t risen with the same oomph as it did in 2009. Ubiquitous analyst David Rosenberg is warning that the “S&P 500 equity models point to roughly a 15% overvaluation right now”.
Ideologically, I’m predisposed to agreeing with the negative skew, not the Vix. The market does seem filled with risks and a number of key metrics that I adhere to (which I’ll discuss more at some point) say we’re getting closer to breaking point.
However, as a pragmatist (and investment director of The Fleet Street Letter newsletter), I will continue to take the rally for all it’s worth.