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A “Vixing” Puzzle Equity volatility has been unusually low for much of 2017. The Volatility Index (VIX), which measures the implied volatility of S&P 500 Index options and has been viewed as a barometer of equity market volatility, has drifted to all-time lows. Over a span of more than 7,000 sessions going back to the start of 1990, the VIX Index’s average and median closing values have come out to 19.4 and 17.6, respectively. It was a rare occurrence for the VIX to collapse below 10 — there were only 9 such occasions out of 6,802 trading sessions prior to 2017, or 0.13% of the times. Year-to-date in 2017, however, there were already 35 sessions with the VIX closing below 10. Another way to look at the lack of volatility is to tally the number of trading sessions when the S&P 500 Index had a daily change of more than 1% in either direction. There were only 8 such sessions so far in 2017, compared to 48 and 72 such occasions in 2016 and 2015, respectively. It seems ironic that the market should be this steady with arguably the most mercurial and unconventional president in modern history at the helm atop the free world. Perhaps investors have grown numb to all the chaos and controversies. It is as if Washington’s dysfunction and a divided America were just fodder for the hyperventilating media, and markets were behaving as if all will be fine when the Republicans pass the tax reform to prime the pump for the 2018 mid-term elections. Time will tell if this period of eerie calm is prescient or misguided. Unintended Consequences The decline in market volatility has made shorting against the VIX futures and various VIX ETPs (exchange-traded products) quite popular and profitable in recent years. The net short position on VIX futures has progressively climbed to new highs over the last couple of years. Another phenomenon was the rise of “volatility control” investment strategies, supposedly favored by many hedge funds and insurance companies. These strategies in essence adjust a portfolio’s allocation between equity and cash to maintain a targeted level of volatility at the portfolio level. In an environment of declining volatility, more assets would be allocated to equities — the equity allocation would even exceed 100% when the market’s realized volatility is below the targeted volatility. On the other hand, as volatility ticks up, the equity allocation would be scaled back. While these strategies have enjoyed strong returns during this stretch of progressively lower equity volatility, they may be planting the seeds of a market correction. Market makers and dealers on the other side of the growing short VIX trades would need to employ various S&P 500 option strategies to hedge their long VIX positions. There is the concern that a decline in the S&P 500 Index could trigger adjustments to these hedging positions that would exacerbate the market decline. Similarly, should volatility suddenly spike up, the aforementioned volatility control strategies would be cutting equity concurrently, which could amplify the market decline similar to the downward selling pressure that the so- called portfolio insurance products generated during the crash of 1987. We wonder if any investors and regulators truly appreciate how these strategies, in concert with various rapid fire trades generated by machine-learning based algorithms, could impact market movement and liquidity should there be an exogenous shock. Only time will tell. exposures Fear vs. Greed There is an adage that one should be fearful when others are greedy and greedy when others are fearful. Judging by the depressed levels of the VIX Index, the enthusiastic speculation over bitcoin as well as other variants of cryptocurrencies, and surveys that indicated strong investment sentiment, it is clear that greed has been on the rise. Can this euphoria continue for a while longer? Of course. However, in our opinion, the combination of elevated investor complacency and a tightening Fed makes the market vulnerable to a pullback, though the timing of it is hard to predict. The aforementioned issues with various trading strategies could further add fuel to fire in the event of a market decline. That said, with the macro and earnings backdrop remaining positive, we would view potential selloffs as a buying opportunity rather than the start of a protracted market downturn. e MONTHLY MARKET REVIEW NOVEMBER 2017 3 HOUSE_OVERSIGHT_012097