A vote in favor of a "Brexit" could send volatility soaring, but don't jump out of equities just yet
The June Federal Open Market Committee (FOMC) meeting passed with few surprises, as market participants were assigning a near-zero probability of a rate hike, and the Fed obliged. Additionally -- and perhaps of little surprise to market participants -- the revised projections of future rate hikes remained the same for this year and were revised lower for 2017 and 2018 on the heels of May's dismal employment report.
The post-Fed price action is what we found most relevant, with SPDR S&P 500 ETF Trust (SPY - 206.52) highs occurring at the April 27 close, the date of the prior FOMC meeting, when the knee-jerk reaction was to push the sell button. As you can see on the chart below, the late-April close had served as support late last month and early this month. But in the minutes following the Fed's decision, the April 27 close acted as resistance, perhaps hinting that Fed uncertainty into the future remains a source of concern for investors. This level, just below the round $210 level, is one that we'll pay attention to on rallies.
"Despite lingering uncertainty in the coming months that ranges from the Fed to a potential 'Brexit' to the presidential election, the sentiment and technical backdrop warrant a bullish view on the market ... As we have observed in the past couple of weeks, our chief concern in making the bullish case is the extreme short position among large speculators on VIX futures, who have historically been wrong just ahead of big directional moves in the VIX. If you want to hedge a long portfolio with the SPY at chart resistance, consider the purchase of calls on VIX futures."
-- Monday Morning Outlook, May 31, 2016
With June expiration and the June Federal Open Market Committee meeting in the rear view, the next major event (which I am pretty certain you have heard about) occurs later this week, when Great Britain voters decide to stay or leave the European Union ("Brexit") in a June 23 referendum. The media has covered this extensively, as fund managers position themselves against a "worst-case" scenario by underweighting exposure to the U.K, or bidding up currencies perceived as safe, such as the Japanese yen, and shorting currencies perceived as "at risk," such as the British pound. Moreover, there has been a flight into gold and bonds.
The eye-popping move of the week was an asset called "volatility," as measured by the CBOE Market Volatility Index (VIX - 19.41). Per the excerpt above, and throughout the month of June, I have noted the huge net short position among large speculators on VIX futures. This was presented as a risk to the equity market, and with uncertainty related to "round-number" technical resistance, the Fed, and a "Brexit," the purchase of VIX futures calls have been recommended as a portfolio hedge.
This hedge has worked out better than expected ahead of the June 23 vote across the pond, as the growing "Brexit" uncertainty spurred a huge increase in volatility, amid a mild decline in stocks. In fact, from June 3 to June 13, the VIX surged by more than 50%, with the S&P 500 Index (SPX - 2,071.22) down only about 1%. It was the first time on record that the VIX has experienced this type of move on such a mild decline.
This "pre-Brexit" action so far has fit nicely with our theme that most sentiment indicators suggest little downside risk for stocks relative to upside reward, all in the context of heightened risk of a volatility pop. It was for this reason that we recommended calls on volatility futures as a hedge, as normally a volatility pop is coincidental with a stock drop.
My sense is British voters will choose to stay in the EU, opting for the status quo before taking a leap into the great unknown. So, the likelihood is volatility heads lower on such an outcome. However, as a guest on a CNBC segment last Thursday, discussing crowded "Brexit" trades and how to play "Brexit," and agreeing with panelists that we don't know how the vote will play out, I presented viewers a way to play this unknown. It is twofold advice that you are probably familiar with:
- U.S. stocks look to have little downside risk compared to upside reward when observing the technical and sentiment backdrop. Therefore, stay invested in equities.
- I am perplexed by the large short position of Large Speculators on VIX futures. The positioning of these speculators is at odds with many others, who have raised cash amid the growing macro uncertainties. Given the potential unwinding of the short VIX futures trade, a "leave" vote could create a huge volatility surge and thus VIX calls are an excellent hedge to your long portfolio.
Updated data on the positioning of large speculators on VIX futures in the weekly Commitment of Traders (CoT) report was made available on Friday. Less than 25% of the previous week's short positions on VIX futures were covered during last week's volatility surge. This suggests that there is still room for the short volatility trade to be unwound.
Therefore, short-term VIX calls remain an attractive portfolio hedge in the event that market participants react unfavorably to the outcome of this overseas event, as continued unwinding of the short volatility trade would result in volatility futures soaring, allowing a VIX call buyer to cash in with hefty profits to offset losses on long portfolios. Again, we think it is more likely that stocks climb and volatility drifts lower after the referendum, but this isn't certain, and we see short volatility speculators as particularly vulnerable to a negative surprise.
Read more:
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