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BofA: "The Market Implies There Is No Way A Shock Can Happen"

For today's moment of volatility zen, we go to BofA's Nikolay Angeloff who drew the short straw to be the (un)lucky pundit whose comments on record complacency, low volatility, etc publicized.

Angeloff starts with pointing out what we noted over the weekend , namely that we have now recorded 334 days without a 5% or more pullback (and 335 after today's close), the fourth longest period on record since 1928.

In another market distortion, whether due to ETFs or central banks, equity vol has fallen so far in October, historically the most volatile month of the year, and if it continues at this pace, it will be the least volatile October in history...

... and third least volatile month ever.

Looking at the above two charts, it is no surprise that at this 30yr anniversary of the ’87 crash, the BofA analyst concludes that "the market seems to currently imply there is no way a shock can happen. However, in part due to today’s low realized volatility creating a steep implied term-structure, along with higher fragility driving steeper skew across tenors, the entry point for “S&P fragility hedges” in the form of put ratio calendars has never been more attractive."

We'll have more to say on his (costless) hedge recommendation tomorrow, but first here is some more on what the ongoing market distortions mean in practical terms:

Markets mark the 30Y anniversary of Black Monday midst chatter of fragility. On 19-Oct-1987, the S&P 500 experienced its worst day in history (since 1928) when the index plummeted 20.5% in a single trading session. The total loss over the month leading to and including the market crash amounted to 27.6%, a 6.6-sigma event.

 

 

Counter to many peoples’ common belief, a shock of this magnitude would be unprecedented today. Our previous work has shown that there is historically a limit of how large shocks can be based on the prevailing realized volatility. With today’s much lower levels of realized vol, a 6.6 sigma event would correspond to a lesser monthly selloff of only 11.5%

Well, as long as it is "only" 11.5%, one can probably count the number of central banker suicides on "only" one hand as these central-planning mandarins watch the fruit of their centrally-planned labor go up in smoke.

Angeloff's conclusion:

"generally, the longer time passes without an abrupt market correction, the higher the likelihood of it happening. Markets pricing very little potential for a shock seems at odds with still elevated geopolitical and policy risk globally. Additionally, some have increasingly refocused on quant fund positioning risks, and as we have argued previously CTA and risk parity flows (and the fear of them) can add fuel to (but not cause) a potential sell-off. Notably we see their equity allocations likely at a high (for CTAs this is due to the coincidental occurrence of a strong trend in performance and record-low vol). Thus, an equity sell-off or an uptick in volatility could cause these portfolios to de-lever their equity allocations and so could exacerbate an equity market correction (Charts 14 & 15). However, we still do not believe they would be the sole drivers of an ’87 style crash.

* * *

Two final observations:

For Oct-17, the VIX settled at 10.53, which is 10.6 points below the 2004-2016 October average of 21.2 (less than half). This is the greatest difference between a monthly settlement and monthly average so far in 2017. For comparison, Sep-17’s settlement of 9.87 was 9.82 points below the September average, the second largest discrepancy so far this year. What’s more, on an absolute level October has the second highest monthly settlement on average (21.2), second only to November (22.0). Regardless, Oct-17’s 10.53 was the second lowest monthly settlement realized thus far in 2017.

In stark contrast with historical trends, realized volatility on SPX has dropped in the month of September and if volatility does not pick up materially from here, the month of October will mark the second monthly drop in a row. Indeed, realized volatility in the month of October thus far is 3.5 vol pts. If realized volatility remains flat for the remainder of the month, this would be the third lowest monthly volatility in the history of the index, which realized less volatility only in Feb-64 and Aug-65. Historically SPX realized volatility tends to drop in the month of November. However, this year may witness a break of that pattern given the likely low level for the month of October. In addition the real battle over tax reform will likely start in early November and that the process from here will neither be pretty or smooth...