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Santoli: Market making volatility calls look silly

A trader on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters

Horror movies and approaching storms have trained us to fear a quiet stillness. So it's little wonder the unusually calm stock market of recent weeks is seen by many investors as more eerie than soothing.

This unease with a steady tape with indexes at record highs is even tougher to take because bulls and bears alike came into this year and out of the wintertime panic insisting that jarring volatility would likely persist. Google "market volatility is here to stay" and the page fills with this assertion repeated by the likes of Jamie Dimon, Vanguard Group, Russell Investments and Wells Fargo investor survey respondents.

Not so much. On 19 of the past 21 trading days, the has moved less than 0.5 percent, a record of static action not seen since September 1995.

The market lull is not just about late-summer doldrums. In fact, August – as widely noted two weeks ago – is among the weakest and most unsettled months of the year.

It seems the market panic following the Brexit vote in late June drove an outsized selling response that was quickly reversed - in large part because professional investors were already positioned defensively. The rebound coincided (by happenstance) with a marked firming in U.S. economic data and better-than-feared corporate earnings.

Meantime, global interest rates have stayed anchored by central-bank exertions abroad and a broadening sense that the bar for a Federal Reserve rate boost was set quite high. With yield-centric stocks now so important to the indexes, bond-market calm is also suppressing equity volatility. And the breakout by the S&P 500 to new highs after 14 months in the red got the trend-followers aboard.

The question now is whether this confluence of market-friendly forces has largely played out, or if we're in for a prolonged stretch of unhurried markets with an upside tilt.

The CBOE Volatility index settled at 11.5 Friday, near the very low end of its usual range and about seven points below its long-term median level.

VIX is mostly just a coincident indicator of stock-index jumpiness (or its absence), but traders habitually see a low VIX as a sign of "complacency" or a market heading for a shock.

The record doesn't quite support this view. A study by Mark Hulbert of Hulbert's Financial Digest showed the performance of stocks up to two months after the VIX sinks below 12 is indistinguishable from when it's gone above the 18.6 average level.

And without suggesting any comprehensive similarities between today's world and economy and conditions a decade ago, low-volatility conditions persisted for most of the 2004-2006 period.

Still, there has been a spurt in volatility during August in each of the past seven years. And since 1990, even in the calmest September (again, in 1995) VIX reached a high of 14. In 2013, the most imperturbable year of this bull market, VIX spent September in a range of 12.5 to 17.5.

Professional investor and blogger Urban Carmel cites the August pattern and speculates that the recent volatility drought and tight trading range could give way to a choppier market just as the S&P 500 nears another round number: 2200, less than 1 percent higher than Friday's close.

There would be a nice synchrony in stocks' new trading range topped by 2200 the way 2100 essentially capped the market for months on end after stocks had run ahead of corporate fundamentals.

Dana Lyons, of J. Lyons Funds Management, points out that securities dealers (often seen as the "smart money" in futures markets) are currently holding unusually large positions in VIX futures that would profit from a spurt in volatility.

So the odds strongly suggest that the market won't stay quite this placid. Yet a few points tacked on to this gauge of options-trader expectations wouldn't necessarily come with severe downside for stocks. A little late-summer storm and a pullback of a couple or few percent in the indexes from all-time highs would not endanger the strong uptrend that began six months ago.

Bank of America Merrill Lynch strategist Michael Hartnett asserted late last week that "the next thrust higher in risk assets will likely complete the rally from the February lows." The time to turn more cautious on equities and risker corporate bonds will be when investor positioning turns clearly bullish, monetary-policy expectations becomes complacent and corporate-profit forecasts get more optimistic.

"We think the optimal moment for this is likely after a mini-melt-up in risk [markets] ahead of Jackson Hole which causes expectations of a 'zero rate, zero vol' future to peak," Hartnett says. The Kansas City Fed's Jackson Hole retreat, which has featured market-moving policy pronouncements in years past, takes place next week, with Fed Chair Janet Yellen speaking on Friday, Aug. 26.

Hartnett counsels investors to stay long stocks, but also to own bets on higher volatility. This is reasonable, though investors have been treated badly by their voracious appetite for "volatility plays." The most popular instrument is the iPath VIX Short-Term Futures ETF (VXX), which is really a day-trading instrument that is forced to pay up for expensive volatility insurance that erodes its value inexorably over time. Even after declining 54 percent this year, the fund has more than $1.4 billion in assets.

Other prudent-seeming hedged strategies all impose some cost. The Janus Velocity Volatility Hedged Large Cap ETF (SPXH) owns index ETFs along with volatility-futures funds as partial protection. This year it's up 4.5 percent compared to 6.8 percent for the S&P. Two percentage points might be worth paying for some peace of mind, but that's a healthy chunk of what the market's gained for 2016.

Only a nasty bear market will make such hybrid strategies truly satisfying to most investors.

For now, perhaps the best approach to a possible volatility eruption is to expect it, get stock exposure to a comfort level before the storm, and and ride it out in the knowledge that most pass without inflicting crippling damage.