May 22, 2020
As we head into the long holiday weekend, let’s take a look at a key chart.
In a world that has been gripped by fear, this chart plots the level of fear in the stock market (better known as the ‘fear index’).
The VIX tracks the implied volatility of the S&P 500. It’s not actual volatility, as might be measured by the dispersion of data from its mean. Implied vol has more to do with the level of certainty that market makers have or don’t have about the future.
When big money managers come calling for an option, to hedge against a potential decline in stocks, a market maker prices the option with some very objective inputs. But also with a very important subjective variable, called implied volatility. When uncertainty is rising, this implied volatility value rises, to include a very healthy (sometimes absurdly high) premium over actual volatility.
To put it simply, if you are an options market maker, and you think the risk of a sharp market decline is rising, then you will charge more to sell downside protection (ex: puts on the S&P) to another market participant — just as an insurance company would charge a client more for a homeowner’s policy in an area more likely to see hurricanes. And, in this vein, market makers are quick to aggressively raise the “insurance premium” if they are confronted with a shock event that leaves them with little-to-no information from which to evaluate risks.
That translates into the violent spikes in the VIX that you can see on the chart.
But, it’s important to note, betting a high VIX to persist, has been a bad bet.
Now, with this in mind, as we’ve discussed in historical crises Wall Street panics well before Main Street panics. And by the time Main Street panics and starts purging stocks, Wall Street is buying. That’s precisely what we’ve seen, this time around. In line with these actions, as you can see in the VIX chart, “the fear” on Wall Street, related to the health crisis, has subsided dramatically.
That’s the world of financial markets. But don’t underestimate the financial market mechanism for pricing in all of the information and laboriously weighing the risks and rewards.
So, what’s the takeaway: The market is telling us that that the psychology of fear on Main Street (which continues to be high) is way out of line with the reality of the health crisis (the status and outlook of which has improved dramatically). With businesses reopening and people returning to work, that Main Street fear should subside — maybe quickly, as people return to their life-learned patterns and behaviors.
Have a safe Memorial Day weekend!