After Calling April’s Whimpering Volatility Spike, MKM Derivatives Analyst Left Wondering When Shoe Drops

Volatility has been acting “odd,” a research note from MKM Partners observed. Back on March 6, when the research provider made the projection that volatility spike was likely to rise again in the intermediate term, they did so based on historical pattern analysis rather than a fundamental market call. Volatility did jump, but even that relative spike was abnormal.

Forecasting a stock market crash and resulting major volatility spike can be a challenging task

Perhaps one of the most difficult feats in forecasting is accurately predicting a market crash. The feat has been partially accomplished only once when in 2015 JPMorgan’s Marko Kolanovic forecast a flash crash approximately in the middle of a major crash.

When Strugger made his March 6 call that volatility would come back, the underlying VIX index was trading at 11.17. There is no exactly predicting when volatility is going to spike, but after a couple of fits and starts, at the end of the month it rose from the dead. The fundamental backdrop for the move was upcoming French elections and concern over the debt ceiling. By April the fear gauge had risen to 16.19 on April 16.

It matters not the fundamental underlier, however. Strugger relied on pattern analysis with a bent towards near-term statistics. “As always, this view was based on the natural oscillations we expect of volatility and not a fundamental assessment of any particular risk event,” he observed, putting into play the recent pattern of volatility rising then rapidly falling on a 4 to 4.5 month basis.

Even though the market call was relatively accurate, the spike in volatility to just the 16 level seemed odd and non-threatening to Strugger, as if “volatility” could be defined by someone being surprised by a birthday party.

It was an odd bout of volatility. Since VIX’s inception, nine-day declines in spot larger than the recent slide ended at an average of 17. Those correspond to shocks where VIX peaked in the upper 20’s. So on a historical basis, the pace and magnitude of the recent implied volatility plunge is unprecedented. For us, that raises more questions than it answers and also muddles the debate about structural volatility.

Even though he called the volatility spike, there wasn’t much to it, which was odd.

Entering 2017, we argued for a return to normalcy in the volatility cycle. This view embedded an expectation that a U.S. economy approaching eight years in duration and amidst Fed tightening and an eventual reduction in the assets held on its balance sheet, equity risk would re-price. Baseline equity volatility should, in turn, shift a few points higher and expose the market to higher-magnitude shocks. The late 1990’s have long been our preferred analog and then, the backdrop of elevated volatility was coincident with strong late-cycle performance in equities.

The fact volatility couldn’t rise to meaningful levels leaves a bad taste in his mouth. Volatility is a natural market reaction and volatility suppression typically leads to more devastating market moves than allowing the angry teenager to vent his anger at will. Ultimately that volatility will implode again.

“While we are respectful of the recent volatility collapse and powerful move up in equities, we think the inability of VIX to lift above 16 and effectively reset the cycle remains an overhang,” Strugger wrote, pointing out that he had previously argued for a “return to normalcy in the volatility cycle.”

This isn’t normal and Strugger has yet to witness the return to such normalcy.