Leavin' lost Vega!

Location Date: 
May 13, 2014

I received a post from Ben Hunt at Salient Partners entitled "Equity Volatility-of-Volatility Falls to All-Time Low" (be sure to check out his very interesting Epsilon Theory website - hat tip to Mike H. for the introduction!). It took a bit for this post to sink in - I mean how could we be below 2007 at the last market peak? As Mr. Hunt notes:

“How is this possible, you ask, with outright war simmering in Eastern Ukraine and China flexing its muscles in the South China Sea? Because Mario Draghi is "signalling" that he's going to launch a European version of QE. Because the Narrative of Central Bank Omnipotence has never been stronger, and for markets this is the only thing that matters. Because we continue to live in the new Goldilocks environment, where mediocre growth is not so weak as to plunge us into recession but not so strong as to take central banks out of play. If the news gets a lot better the market will go down, and if the news gets a lot worse the market will go down. But what I call the Entropic Ending, a market-positive gray slog where global growth is more-or-less permanently crippled by the very monetary policies that prevent global growth from collapsing, can go on for a looooooong time”.

Hunt is developing a model of sorts based on game theory, history and behavioural analysis to help “explain” why markets act the way they do. As many readers know, I subscribe to the view that behavioural analysisis a very important component of understanding security and market actions.Hunt of course is referring above to the concept of Narrative Fallacy (see prior posts on Kahneman) when referring to central bank omnipotence.

But back to the VIX again. Deutsche Bank’s strategist David Bianco produced an interesting gauge of the market’s emotional level i.e. P/E÷ VIX.  The accompanying chart plots this relationship over time. Given that we are now entering a period of “complacency” (at least from a historical standpoint), caution is warranted. Butt hen as many market commentators have stated “What do you do with the cash if you take profits?”  The central bankers want you to take more risk.  We would suggest a few other alternatives!

PE/VIX = market emotion: lately drifting in and out of complacency
We define 5 categories of market emotion gauged by PE/VIX: 1) Crash - very high VIX and low PE, 2) Skeptical/Denial - VIX elevated and PE still low, 3) Realistic/Disciplined - Both PE and VIX within normal ranges, 4) Complacency - low VIX or high PE or both, 5) Mania - very high PE and low VIX.

Jim McGovern