The final session on the first day of Risk Management was titled Intersections Between Macroeconomic Conditions and Volatility Levels. Benn Eifert, Ph.D., Former Portfolio Manager from Mariner Coria and Stacey Gilbert, Head of Derivatives Strategy at Susquehanna teamed up for a very informative and educational session.
Eifert started things off discussing the relationship between the economy and equity market volatility which is an area that the markets are very focused on for 2016. His first statement was that equity market volatility is often associated with economic downturns. Eifert acknowledged that this is common knowledge and should not be a surprise to anyone. His explanation of this is that forward earnings expectations become more difficult to predict when there is economic uncertainty. This results in higher equity market volatility or an increase in VIX. He also noted that small cap volatility is more sensitive to deteriorating economic conditions than large cap volatility.
Gilbert then took over with a focus on ‘where we are now’, using Eifert’s words when he introduced her. She mentioned that she has more of a trading background so her experience involves looking at and then interpreting the markets.
She noted that VIX is relatively high when compared to the long term average and discussed SPX skew through comparing out of the money calls to out of the money puts. She pointed out that puts were recently expensive relative to calls, but the issue was cheap calls, not necessarily expensive puts. The expense of puts relative to calls has actually come down a bit in 2016.
Sticking with the comparison of different volatility levels, she noted that the cost of protection using Russell 2000 Index options is cheap when compared to using S&P 500 Index options. The Russell 2000 has under performed relative to the S&P 500 as concerns regarding growth weighted on small cap stocks more than large cap stocks. She finished up on this topic noting that the convergence of Russell 2000 and S&P 500 implied volatility has historically not been a positive for the equity market. She noted that financial sector volatility is at a relatively high premium when compared to the overall market. A final point was that using a back of the envelop estimate using SPX option pricing places the odds of a 2016 recession at about 30%.