The markets have been in a stage of extreme positioning for some time, but just when it looks like volatility is about to approach average levels, it turns right back around. The VIX surged more than 40% on Thursday following President Trump’s comments to North Korea about its nuclear tests. But odds are that the VIX is head-faking the markets, and with volatility at such low levels for so long, investors have been so focused on the Tech sector that they’ve given it multiple personalities.
Extreme positioning at a crossroads
The Volatility Index reached the highest level since November and recorded its sharpest one-day climb since May, according to data from FactSet. Over three days, the VIX climbed more than 60% for its largest jump in two years, according to Bloomberg BusinessWeek. However, in each of the last six times when the VIX has climbed that much so fast, it tumbled in the next month, falling by 27% on average, and so the low volatility rut continues and feeds the extreme positioning narrative that's going on.
Goldman Sachs analyst Robert Boroujerdi and team outlined all the pieces of the puzzle in their Aug. 8 "Portfolio Manager Toolkit" report. They explained that the current extreme positioning environment was created at "the confluence of low volatility, a fluid retention narrative and signs of complacency in rates & credit markets."
Tech sector behaves strangely
Because of these conditions, they're particularly watching sector and factor relationships and for signals that a mean reversion could be just around the corner. They explained that the "ebbs and flows of the reflation narrative" have been strongly influence the performances of the sectors and factors, creating extreme positioning in the process.
For example, the Tech sector is usually heavy-laden with characteristics that are found in Growth and Momentum, but in the current environment, they find that the Tech sector has also been acting like a proxy for low-vol bonds. It has also been positively correlated with the Consumer Staples and Utilities sectors and had an inverse relationship with the 10-year Treasury, just as low-vol bond proxies usually do.
Meanwhile, Healthcare has lost the "carry" trait it usually has and lost the low-vol bond proxy characteristics it usually has. Low Volatility is skewed toward Growth and Tech while Value weights are holding below historical levels. The Goldman team warns also that if the Low Vol mean reverted now, it would have a higher vol than the S&P 500.
Yield curve and high-yield spreads
It comes as no surprise that the yield curve has been flattening recently, as it usually does when the Federal Reserve hikes interest rates. However, the Fed will likely start normalizing the balance sheet soon, and interest rates from other countries could have a much smaller effect.
Because interest rates have been so low for so long, investors have been searching for yield. The Goldman team notes that this search for yield, combined with a lack of supply and "benign defaults" have resulted in high-yield credit spreads reaching levels that are the tightest in yields even though policy uncertainty remains high. This is an unusual situation because historically, policy uncertainty has had a strong relationship with high-yield credit spreads.
"High correlation between spreads and factors and elevated skew in HYG suggest equity/ options markets are more concerned about leverage than the credit market," the Goldman team explained.
They also advised investors who are concerned about all this to watch their exposure to Growth and to companies that have balance sheets that are stretched.