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The Vol Doctor Is In



February 27, 2018

Your doctor can’t typically diagnose your medical issue without first taking your vitals. Sure, you may have a cough or a sore throat, but the doctor will want to listen for gurgling in your lungs, take a blood pressure reading and check your body temperature. She may also want to take blood or urine samples to investigate further. As traders, we approach things in a similar way.

At the moment, the market feels very quiet and orderly following that fairly sharp and unexpected drawdown in early February. Markets caught a bit of the flu, but we needed to scrape below the surface of what we witnessed for evidence that something more insidious could possibly be going on.

A persistently higher VIX is telling us that all is not well, yet. “But don’t worry, you might say. “We’ve bounced back many times from selloffs, right?” Yes, that has been true in the past, but let’s check the market’s blood pressure and body temperature. S&P 500 Index fund outflows were indeed very significant in early February. V-shaped market recoveries haven’t been anything unusual in the past five years, but these record outflows are something to note. A lot of that money went into flight-to-safety money markets. Many investors seem to be getting nervous about rising rates, wage inflation and the end of heavy handed central bank stimulus. Yields now appear to be heading towards what some would call ‘a reasonable-ish alternative’ to equities, following years of TINA (There Is No Alternative).

This past year’s massive wave of cash into markets has been akin to a huge ship moving in one direction. It possesses a great deal of momentum, but once it slows and changes direction, the opposite effect can happen.  I hate to argue with momentum, but could we be seeing evidence of this slowdown? Treasury yields are indicating that the punch bowl is being taken away. Junk bond outflows have been very large – evidence of investors pulling back from the end of the risk spectrum, where they have been precariously perched against their will. Sure, things are improving in the economy, but there are concerning signs of pricing pressures and we’ve just received some not-so-subtle wake-up calls.

The BetaPro S&P 500 Vix Short-Term Futures™ ETF (HUV) has recently been gaining about 45 basis points a day in value from positive roll yield due to an inversion in the front two VIX futures. That is something that rarely happens – 85% of the time the structure in the VIX futures contributes to a negative drag in short-term long volatility products. However, that’s not the case right now. This tells us that the market is still nervous about something. Actual volatility in the S&P 500 Index is dropping, so admittedly VIX futures will have a tough time staying this high – but at this point the edge is in being long volatility. This is also a great potential recipe for covered calls – high option pricing and equities that probably won’t be soaring to new highs.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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