GO AHEAD -- GAMBLE ON A CALM MARKET. WHAT COULD GO WRONG? / BARRON´S MAGAZINE

Go Ahead—Gamble on a Calm Market. What Could Go Wrong?

By Randall W. Forsyth
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Photo: Getty Images/iStockphoto 

Party like it’s 2017? Speculators are once again betting the stock market’s return to low volatility will persist despite the array of uncertainties it faces.

Unlike last year, however, when amateurs piled into complex and risky exchange-traded funds that moved inversely to the VIX—the Cboe Volatility Index on options on the S&P 500—it’s professionals who have ramped up their short positions in VIX futures and options contracts his time.

David Rosenberg, Gluskin Sheff’s lynx-eyed chief economist and strategist, points out speculative shorts in the VIX nearly doubled last week, to 44,380 futures and options contracts, from 25,556 the previous week, according to the most recent data from the Commodity Futures Trading Commission. “This is the largest net short we have seen since prior to the violent February sell-off that was in fact accentuated by these products,” he writes in his “Breakfast With Dave” daily commentary.

At that time, stocks tanked as the VIX surged amid suddenly heightened uncertainty over interest rates and inflation. As reported in this space then (“The Real Cause of Stocks’ Big Stumble,” Feb. 10), expectations of more-aggressive policy tightening followed news of accelerating wage growth indicated in the January employment data. That, in turn, upset the market’s presumption of slow, predictable interest-rate increases—a big factor underpinning the historically low volatility in all markets, from equities to government securities to currencies.

Betting that the future would be like the recent past, complacent speculators piled into wagers on persistently subdued volatility as a sure thing. That was aided and abetted by the ready availability of products such as the now-shuttered VelocityShares Daily Inverse VIX Short Term exchange-traded note, which was known mainly by its ticker, XIV, rather than the mouthful of its title.

As the VIX soared from a low in the single digits last year to a peak over $50 in the ensuing market mayhem in February, the sure thing came a cropper, as they almost inevitably do. XIV lost 90% in value before its sponsor liquidated the ETN, wiping out many speculators and producing the inevitable lawsuits.

While XIV is gone, the ProShares Short VIX Short-Term Futures exchange-traded fund (ticker: SVXY) soldiers on and has quietly climbed 23% since April 2, to $13.67 at midday Wednesday, though it remains 90% below its 52-week high of $139.47. But that’s not where the pros play; they use VIX futures and options on the Cboe to take advantage of the steady decline of the stock market’s so-called fear gauge as it has steadily receded through the teens to a hair above 12 Wednesday.

That’s a sign of complacency returning to the market, Rosenberg writes: “Pretty incredible to see this sort of position from the fast-money crowd given the very real possibility of a trade war on the horizon.”

That is far from the only uncertainty overhanging global financial markets. Perhaps the least extraordinary source of risk is that of global monetary policy.

The Federal Open Market Committee meets next week, and the policy-setting panel is all but certain to vote an additional quarter-percentage-point increase in its federal-funds target range, currently set at 1.50%-1.75%. What market participants really want to know is the expected outlook for further hikes, specifically if there will be one more hike this year or two.

Even more uncertainty surrounds the European Central Bank’s outlook. The ECB could outline plans at its policy meeting next week to unwind its bond-purchase program, according to various media reports. Market participants and policy makers well remember the “taper tantrum” of 2013, when the Fed merely disclosed plans that it was contemplating a reduction of quantitative easing securities purchases. The actual reversal of QE did not begin until 2017.

In addition to conflicts on the trade front and monetary policy, there are also the minor matters of geopolitical conflict and this year’s midterm elections.  
Nevertheless, bullish sentiment continues to rebound. According to the latest Investors Intelligence poll of advisory comment, bulls rose to 52.9% from 50.0% in the previous week, nearly 10 percentage points above the early May reading of 43.1%.






Bears dipped to 17.7% from 19.2% the two preceding weeks. The spread between bulls and bears widened to 35.2%, from 30.8% the previous weeks and just 22.5% in early May. That widening bull-bear gap moves Investors Intelligence to observe: “Risk is now rising.”

Yet speculative bets are going in the other direction. The buildup in short positions in VIX futures and options implies either growing confidence or, as Rosenberg suggests, complacency.

The last time those sentiments prevailed was when the S&P 500 and Dow Jones Industrial Average reached their peaks last January. Those marks are again being approached but haven’t been topped, just as the market’s fear gauge fades.