Let’s get the Dow Jones Industrials all-time highs out of the way. This market feels like it will be easier to handle once that psychological benchmark is taken out. Because when I stack the positives vs. negatives of the current market backdrop, the biggest positive is the psychological excitement surrounding a new all-time high on the high-profile index. Against that, the list of negatives is extensive, as global equity markets from Europe to China break down, commodities remain weak, the dollar continues to strengthen, and defensive sectors continue to lead on the upside.
In the past several weeks, volatility has picked up, but the S&P 500 is basically in the same spot it was 3 weeks ago. Interestingly, volatility markets have priced in a resumption of the low volatility regime going forward, even as realized volatility has been a bit more elevated. Here is 30 day implied volatility vs. 10 day realized volatility in the SPX plotted over the last year:
The current reading is one of the few instances in the past year where 10 day realized volatility (white line) is higher than 30 day implied volatility (red). Of course, since 10 day realized volatility has hardly moved above 20 at all in the past year, traders are quick to sell any spike in volatility in this environment.
The high realized vol against low implied vol backdrop is one reason why we have initiated fewer range trade strategies in the past few weeks compared to the start of 2013. Trades that benefit from low volatility do not offer attractive risk/reward opportunities. Clearly, traders in the options market expect realized volatility to move lower. But given the cross-market indicators flashing caution, I’d rather not join the herd in that expectation.
Markets overnight:
- Asian markets followed the U.S. into the green, led by the Shanghai Composite up 2.3%, bouncing after Monday’s severe loss.
- Europe opened green and has remained in the green all session, up about 1.5% right now. EU officials signaled less stringent budget restrictions to ease austerity.
- SPX futures hit the previous 1530 high overnight, and are now up 0.3%. The all-time high on the DJIA of 14,198.10 will be closely watched today.
- The dollar is slightly lower, along with Treasuries, and commodities are mostly higher.
- ISM Non-Manufacturing Composite at 10:00 am EST. Expectation of 55.