Stocktake: Sleepy markets vulnerable to volatility spike

Overconfidence in CEOs not always bad and it’s too early to know if pound has bottomed

Sterling enjoyed a decent bounce last week, following better-than-expected economic data. Photograph: Chris Radburn/PA Wire

Sterling enjoyed a decent bounce last week, following better-than-expected economic data. Photograph: Chris Radburn/PA Wire

 

August tends to be a quiet month for markets and things are especially sleepy at the moment.

The S&P 500 hasn’t moved up or down by 1 per cent on a single day since early July; there have been only a handful of days on which the index moved by 0.5 per cent or more. Average daily changes over the last six weeks have been the lowest since 1995.

Trading volumes have plummeted by 30 per cent since January, according to Credit Suisse, compared to a typical January-August drop of 8 per cent. Volatility in emerging markets, too, has fallen to its lowest level in more than a year.

Fear has vanished. The Vix, the so-called fear index that measures the cost of buying insurance against market declines, recently hit its lowest level in two years. Although insurance appears dirt cheap, many expect it to get cheaper – hedge funds’ net short in Vix futures is near record levels,

This is a “red flag”, cautions Merrill Lynch; selling volatility to enhance yield “is now at an extreme level”. In itself, a low Vix doesn’t indicate complacency, and low volatility can persist for years. However, market speculators appear vulnerable to any spike in volatility; traders betting on a lower Vix will be hoping the current sleepy spell doesn’t end any time soon.

Short squeeze drives sterling bounce

Sterling enjoyed a decent bounce last week, following better-than-expected economic data, but it’s far too early to say whether the pound has bottomed.

The recent rebound appears more of a technical rebound than one solely driven by fundamentals. Since sinking to a three-decade low against the dollar two months ago, sterling has remained within a $1.28-$1.34 trading range. The recent rebound coincided with the pound falling to the bottom of that range. More crucially, short bets against sterling had climbed for seven straight weeks; by mid-August, net short positions had hit record highs and were more than three standard deviations above their historical average.

No asset rises or falls in a straight line; lopsided market positioning meant conditions were ripe for a short squeeze. However, many sellers may reinitiate short bets if sterling rises to the higher end of that aforementioned trading range, especially as the economic impact of Brexit will not become clear for some time. A technical bounce should not be mistaken for a long-term bottom.

Don’t fear low trading volumes

Trading volumes have been extremely low over the last month. Indeed, while volumes soared during the January-February selloff, the subsequent six-month rally has been a low-volume affair, troubling commentators who associate low volumes with low conviction.

However, there is no substance to the oft-repeated notion that volume should confirm price, judging by Bespoke Investment Group research. Since the bull market began in March 2009, the S&P 500 has gained an incredible 826 per cent on days registering below-average trading volumes. In contrast, stocks have fallen by 65 per cent on days recording above-average trading volumes.

In other words, a strategy based on the “low volume bad, high volume good” theory has been a fast way to the poorhouse over the last seven years.

Frustrated investors pulling money from hedge funds

Investors may be losing patience with hedge funds, which last month suffered net outflows of $25.2 billion (€22.5bn) – the biggest monthly redemption since February 2009, according to eVestment.

With similar outflows reported in June, hedge funds appear set to suffer net annual outflows for only the third time in history, and the first since 2009.

It’s surprising it has taken so long. A US 60:40 equity:bond portfolio would have beaten the average hedge fund every year over the last decade. In the UK, too, a 60:40 portfolio would have returned three times as much money as the average hedge fund over the last five years, according to SCM Direct, despite hedge funds’ charging 36 times the fees.

It remains to be seen if 2016 will represent a mere blip for hedge funds or “the first innings of a washout”, as hedge fund manager Dan Loeb warned last April. The latter would be preferable – continuing to pay big fees for lousy returns truly defies reason.

Overconfident CEOs good for stock prices

Overconfidence in chief executives is not always a bad thing, according to a new study (see http://goo.gl/Jw54G9).

. One common way of identifying overconfident chief executives, the researchers noted, is to focus on executives holding deep in-the-money vested stock options (by not selling, they are indicating they expect their company share price will keep rising).

Such CEOs are more likely to provide voluntary earnings guidance, announce stock repurchases and use mark-to-market accounting practices, the researchers found. Increasing information dissemination about the company helps “level the playing field between informed and uninformed investors”, increasing market efficiency and preventing the likelihood of shares becoming undervalued.

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