Although global cross-asset risk is down slightly, the recent rally in U.S. equities has kept implied volatility high for U.S. stock market futures as the VIX reached 16.7 last week, putting it in line with last year’s average. There’s no denying that many of the ingredients being mixed into the global economic and financial pot right now usually just don’t go together, and the result is that it’s become extremely hard for even the best of the best to predict what’s going to happen next, whether it’s with U.S. equities or any other global financial asset.
U.S. equities contrast with the rest of the markets
Bank of America Merrill Lynch analyst Benjamin Bowler and team said their Global Financial Stress Index, which measures cross-asset risk, edged lower by 0.2 last week, bringing it to 0.47, although it still is close to the top end of where it’s been over the last four years in the 80th percentile. However, they also said U.S. equities have rallied so suddenly that short-dated implied volatility has moved sharply lower.
Further, they said while long-term U.S. equities volatility is still very high, it’s highly unusual for the gap between the VIX and the GFSI to be so wide. In fact, they said that gap has only been wider 2% of the time since 2000, which they say is indicative of “the relative extreme optimism priced into this equity rally versus the risks still priced into broader asset classes.” They believe U.S. equities have been underpricing global risk by “close to a record amount since 2000.”
Looking at each asset class, the BAML team said equities had the biggest decline in stresses last week, with currencies and credit following in second and third place.
They added that all of the ten “most significant” changes in stresses compared to history last week were actually declines.
U.S. equities see a record short squeeze
While some argued that there was no short squeeze, the BAML team is of the opinion that we’ve seen a record one, noting that improving fundamentals have helped give market sentiment a boost, although they think technicals have been the bigger driver in the most recent rally in U.S. equities. One reason for this view is because the three-week long rally has witnessed outperformances of some of the most heavily shorted stocks.
Also buy-side net short futures on the S&P are approaching five-year extremes, they said. Further, they said S&P futures have been moving along at 18-year discounts to fair value, which suggests that we haven’t seen the full unwinding of short-positioning.