Global Investment Strategy Report
Global Investment Strategy
Global Investment Strategy Report May 30, 2017 Eric Augustyn Director of Option Strategies Scott Wren Senior Global Equity Strategist
Weekly market insights from the Global Investment Strategy team » Volatility is low, and has remained low for a long time. Yet, investors shouldn’t necessarily assume a quick reversion to average historical equity volatility levels. We believe that the low-volatility environment could persist somewhat longer. » The VIX (Chicago Board Options Exchange Volatility Index) is a coincident (not forward-looking) indicator that actually offers little insight into forward returns and future volatility. What it may mean for investors » We believe that hedging strategies should be customized for a specific investor’s equity holdings.
Volatility Hasn’t Been Around Here Lately “Don’t come around here no more.” -Tom Petty In September of last year, when our equity strategy team originally set its year-end 2017 target for the S&P 500 Index, we anticipated that the index would reach “fair value” after trekking down the long road of recovery for seven years following the financial crisis. Our work suggested that the S&P 500 Index would see its highs for 2017 in the middle portion of the year (May, June or July) at—or a bit above— the top end of our 2230-2330 year-end target range. Well, here we are. The market has been spending time just above the top end of our target range since the middle of February. Volatility, as measured by the VIX, has dropped like a rock. 1 That makes sense to us. The S&P 500 Index has been trapped in a “less than 100 point range” for three months without much back and forth price action. Trading volumes have been low as the market plays a wait-and-see game with Washington over whether our elected representatives can agree to—and implement—a fiscal package that will benefit the economy. In our opinion, those potential benefits are likely a 2018, 2019 and 2020 story— not 2017. Where do we go from here? Our views also have not changed since last September on this topic. We see stretched valuations and wage pressures as headwinds for domestic stocks in the second half of this year. Higher wages clearly could weaken corporate profit margins. Our equity strategy work continues to suggest that the tightening U.S. labor market is likely to drive wage growth higher in the coming quarters, and potentially beyond. We wouldn’t be surprised to see average hourly earnings climb to 3 percent on a year-over-year basis in one of the upcoming employment reports over the next 5-7 months— from the latest reading of 2.5 percent. The VIX (Chicago Board Options Exchange Volatility Index) reflects the equity market's expectation of 30-day volatility. It is constructed using the implied volatilities of a range of S&P 500 index options. 1
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 1 of 5
Global Investment Strategy—|—Volatility Hasn’t Been Around Here Lately—|—May 30, 2017
However, we are not yet calling for an end to the cycle. This year, we continue to anticipate low- to midsingle-digit returns for the S&P 500 Index. Our very preliminary work suggests returns next year may be slightly better than that. Additionally, investors are asking: “Is the low VIX signaling complacency and higher volatility ahead, or is a true lack of fear warranted?” A quick internet search of “VIX” yields stories assessing the reasons that the VIX might be low despite underlying uncertainty. This question is asked with the market at all-time highs, populism on the rise, the Federal Reserve raising rates and political uncertainty pervasive in Washington, D.C. With all of these dynamics adding to investor uncertainty, the VIX, considered by some as the “fear gauge,” is showing no fear. What Is An Investor to Think? To start, it helps to understand what the VIX is and how it is determined. The VIX is simply a measure of the equity market’s expectation of volatility as determined by put and call prices of S&P 500 Index options. 2 Furthermore, this volatility expectation is driven not only by these prices, but by traders’ expectations of market returns. When you hear “expected volatility,” that simply refers to how much the market expects returns to vary over the next year. For example, in the case of the S&P 500 Index, if the market expects daily returns of approximately 1 percent, then the VIX would be at approximately 16 percent. Further, expected daily returns of approximately 2 percent would lead to a VIX of approximately 32 percent. 3 In all cases, the lower the VIX or equity-market volatility, the lower the (market’s) expected variance of returns (the opposite holds true as well). In reality, market participants pay more for puts than calls. As a result, the VIX jumps much more in a down market move, compared to the amount of decline in an up market move. Historically, pricing shows that the VIX has a natural floor somewhere around 9 -10 regardless of the extent of the market rally (see Chart 1). Chart 1. VIX versus S&P 500 Index 90
3,000
80 2,500 70 2,000
VIX Index
135 Trading Days Below Median
50 40 30
SPX Index
60
1,500
1,000
20 500 10 0
0 90'
92'
94'
96' VIX
98'
00'
02'
04'
Drawdown Below Median
06'
08'
Median VIX (17.7)
10'
12'
14'
16'
SPX Index
Sources: Bloomberg, Wells Fargo Investment Institute, 5/24/17. Daily data from 1990 through May 24, 2017. Drawdown below median reflects a continuous run of closing levels below the historic median. SPX Index = S&P 500 Index.
2 More specifically, the VIX trades similarly to a slightly “out of the money” S&P 500 Index put option. The VIX is priced from both put and call options with a range of strikes and maturities. Yet, in practice, the level of volatility is closest to a one month put option with a strike 2–3 percent out of the money. 3 In reality, the math is the square root of annual trading days multiplied by the volatility of expected returns. Put another way, the square root of 252 multiplied by 1.0 percent equals 15.8 percent volatility.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 2 of 5
Global Investment Strategy—|—Volatility Hasn’t Been Around Here Lately—|—May 30, 2017
These expectations of volatility shouldn’t be confused with predictability. As shown in Chart 1, over short periods of time, the VIX and the S&P 500 Index have been inversely correlated. 4 That means the market often can rise while the VIX declines, so it isn’t a coincidence that—with the market at all-time highs—the VIX is near long-term lows. To add some more perspective, let’s think about last week’s selloff following presidential impeachment headlines. On Wednesday, as the S&P 500 Index declined by 1.8 percent, the VIX was up 46 percent. As the equity market recovered, the VIX declined. Yet, over longer time periods, the predictive value of the VIX shows almost no correlation (0.048) with forward equity returns. Said differently, an increase in the VIX has almost zero predictability (of signaling) that the market will be higher in the future. A takeaway is that longer-term investing decision making should not be based on the current level of the VIX. Another refrain we hear from the markets is that “the VIX is so low, it has to go up,” similar to “the market has rallied for so long it has to correct.” Since the inception of the VIX in 1990, the median “low volatility” run has been 16 days (excluding very short periods of less than five days). The current running period of low volatility exceeds the median, though historically, it isn’t the longest (see Table 1). A low-volatility period is defined here as a continuous run of closing VIX levels below the historic median. More importantly, the frequency of low-volatility periods has increased since 2012 as depicted in Chart 1. Table 1. Low-Volatility Periods for the VIX Rank 1 2 3 4 5 6 7 8 9 10
Start Date 10/15/1992 12/9/1994 4/18/2005 8/16/2004 4/6/1994 7/19/2006 3/17/2014 11/9/2016 2/10/2015 2/26/2013
End Date Number of Days 3/30/1994 368 3/8/1996 314 5/22/2006 276 4/15/2005 168 11/23/1994 161 2/27/2007 152 10/9/2014 144 5/25/2017 135 6/29/2015 96 6/12/2013 74
Source: Bloomberg, 5/24/17
In addition to these longer, more frequent periods of low volatility, a further complication to the VIX is the speed of reversion of the index. Since 2011, the number of days that volatility remained elevated following a spike has declined (Chart 2). As Chart 3 shows, once volatility jumped on May 17 following headlines regarding potential presidential impeachment, a professional investment manager had just over two trading sessions to try to capitalize on the move.
4 Correlation measures how two asset classes or investments move in relation to each other. The correlation coefficient ranges between -1 and +1. A value of 1 represents perfect positive correlation (as one investment moves, either up or down, the other investment will move in alignment, in the same direction). A correlation coefficient of -1 implies perfect negative correlation (the investments move in exactly opposite directions).
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 3 of 5
Global Investment Strategy—|—Volatility Hasn’t Been Around Here Lately—|—May 30, 2017
Chart 2. VIX Reversion: Days to Recover from Significant Spikes 14.00 13.50 13.00 12.50
Days
12.00 11.50 11.00 10.50 10.00 9.50 9.00
Sources: Bloomberg, Wells Fargo Investment Institute, 5/24/17. Chart shows 30-day moving average of days to Z-score reversion (for the VIX). A spike in this context was measured as a 30 day Z-score break equal to or greater than 2.0. Reversion was then marked as next point at which the Z-score crossed back over zero. A significant spike is an increase in the VIX by at least two standard deviations over its historical mean. The calculation here is shown as a 30-day moving average, in order to see tendencies better. Z-score is a numerical measurement of a value’s relationship to the mean in a group of values. A positive value indicates the score is above the mean and a negative indicates it’s below.
Chart 3. VIX Closing Level: May 2017 (to date) 18 17 16 15
VIX Index
14 13 12 11 10 9 8
VIX Closing Level
Source: Bloomberg, 5/25/17. Data is daily from May 1, 2017 through May 25, 2017. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 4 of 5
Global Investment Strategy—|—Volatility Hasn’t Been Around Here Lately—|—May 30, 2017
Investment Implications The financial press loves to talk about the VIX since it simplifies stock market volatility in a single number. If you say “fear gauge,” many investors understand the concept, while not understanding the true meaning. Certainly, the VIX is useful for understanding the state and behavior of U.S. equity-market volatility. Effectively hedging a portfolio’s equities requires tailoring the potential solution– whether it’s a diversified portfolio or a concentrated single-stock position. We recommend that investors remain broadly diversified at their target allocations—and focus mostly on those equity sectors likely to benefit from a continuation of the recovery. We are overweight the Consumer Discretionary, Industrials, Financials and Health Care sectors. We do not recommend getting overly defensive—and therefore, we currently are underweight the Consumer Staples and Utilities sectors. We also continue to recommend an underweight position in the Energy sector due to very extended valuations.
Risk Factors Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Definitions Chicago Board Options Exchange Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market. An index is unmanaged and not available for direct investment. Call/Put Options are a contract that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specific price on or before a certain date.
Disclaimers Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company. The information in this report was prepared by the GIS division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 0517-05469
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 5 of 5
Global Investment Strategy Report May 30, 2017 Eric Augustyn Director of Option Strategies Scott Wren Senior Global Equity Strategist
Weekly market insights from the Global Investment Strategy team » Volatility is low, and has remained low for a long time. Yet, investors shouldn’t necessarily assume a quick reversion to average historical equity volatility levels. We believe that the low-volatility environment could persist somewhat longer. » The VIX (Chicago Board Options Exchange Volatility Index) is a coincident (not forward-looking) indicator that actually offers little insight into forward returns and future volatility. What it may mean for investors » We believe that hedging strategies should be customized for a specific investor’s equity holdings.
Volatility Hasn’t Been Around Here Lately “Don’t come around here no more.” -Tom Petty In September of last year, when our equity strategy team originally set its year-end 2017 target for the S&P 500 Index, we anticipated that the index would reach “fair value” after trekking down the long road of recovery for seven years following the financial crisis. Our work suggested that the S&P 500 Index would see its highs for 2017 in the middle portion of the year (May, June or July) at—or a bit above— the top end of our 2230-2330 year-end target range. Well, here we are. The market has been spending time just above the top end of our target range since the middle of February. Volatility, as measured by the VIX, has dropped like a rock. 1 That makes sense to us. The S&P 500 Index has been trapped in a “less than 100 point range” for three months without much back and forth price action. Trading volumes have been low as the market plays a wait-and-see game with Washington over whether our elected representatives can agree to—and implement—a fiscal package that will benefit the economy. In our opinion, those potential benefits are likely a 2018, 2019 and 2020 story— not 2017. Where do we go from here? Our views also have not changed since last September on this topic. We see stretched valuations and wage pressures as headwinds for domestic stocks in the second half of this year. Higher wages clearly could weaken corporate profit margins. Our equity strategy work continues to suggest that the tightening U.S. labor market is likely to drive wage growth higher in the coming quarters, and potentially beyond. We wouldn’t be surprised to see average hourly earnings climb to 3 percent on a year-over-year basis in one of the upcoming employment reports over the next 5-7 months— from the latest reading of 2.5 percent. The VIX (Chicago Board Options Exchange Volatility Index) reflects the equity market's expectation of 30-day volatility. It is constructed using the implied volatilities of a range of S&P 500 index options. 1
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 1 of 5
Global Investment Strategy—|—Volatility Hasn’t Been Around Here Lately—|—May 30, 2017
However, we are not yet calling for an end to the cycle. This year, we continue to anticipate low- to midsingle-digit returns for the S&P 500 Index. Our very preliminary work suggests returns next year may be slightly better than that. Additionally, investors are asking: “Is the low VIX signaling complacency and higher volatility ahead, or is a true lack of fear warranted?” A quick internet search of “VIX” yields stories assessing the reasons that the VIX might be low despite underlying uncertainty. This question is asked with the market at all-time highs, populism on the rise, the Federal Reserve raising rates and political uncertainty pervasive in Washington, D.C. With all of these dynamics adding to investor uncertainty, the VIX, considered by some as the “fear gauge,” is showing no fear. What Is An Investor to Think? To start, it helps to understand what the VIX is and how it is determined. The VIX is simply a measure of the equity market’s expectation of volatility as determined by put and call prices of S&P 500 Index options. 2 Furthermore, this volatility expectation is driven not only by these prices, but by traders’ expectations of market returns. When you hear “expected volatility,” that simply refers to how much the market expects returns to vary over the next year. For example, in the case of the S&P 500 Index, if the market expects daily returns of approximately 1 percent, then the VIX would be at approximately 16 percent. Further, expected daily returns of approximately 2 percent would lead to a VIX of approximately 32 percent. 3 In all cases, the lower the VIX or equity-market volatility, the lower the (market’s) expected variance of returns (the opposite holds true as well). In reality, market participants pay more for puts than calls. As a result, the VIX jumps much more in a down market move, compared to the amount of decline in an up market move. Historically, pricing shows that the VIX has a natural floor somewhere around 9 -10 regardless of the extent of the market rally (see Chart 1). Chart 1. VIX versus S&P 500 Index 90
3,000
80 2,500 70 2,000
VIX Index
135 Trading Days Below Median
50 40 30
SPX Index
60
1,500
1,000
20 500 10 0
0 90'
92'
94'
96' VIX
98'
00'
02'
04'
Drawdown Below Median
06'
08'
Median VIX (17.7)
10'
12'
14'
16'
SPX Index
Sources: Bloomberg, Wells Fargo Investment Institute, 5/24/17. Daily data from 1990 through May 24, 2017. Drawdown below median reflects a continuous run of closing levels below the historic median. SPX Index = S&P 500 Index.
2 More specifically, the VIX trades similarly to a slightly “out of the money” S&P 500 Index put option. The VIX is priced from both put and call options with a range of strikes and maturities. Yet, in practice, the level of volatility is closest to a one month put option with a strike 2–3 percent out of the money. 3 In reality, the math is the square root of annual trading days multiplied by the volatility of expected returns. Put another way, the square root of 252 multiplied by 1.0 percent equals 15.8 percent volatility.
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 2 of 5
Global Investment Strategy—|—Volatility Hasn’t Been Around Here Lately—|—May 30, 2017
These expectations of volatility shouldn’t be confused with predictability. As shown in Chart 1, over short periods of time, the VIX and the S&P 500 Index have been inversely correlated. 4 That means the market often can rise while the VIX declines, so it isn’t a coincidence that—with the market at all-time highs—the VIX is near long-term lows. To add some more perspective, let’s think about last week’s selloff following presidential impeachment headlines. On Wednesday, as the S&P 500 Index declined by 1.8 percent, the VIX was up 46 percent. As the equity market recovered, the VIX declined. Yet, over longer time periods, the predictive value of the VIX shows almost no correlation (0.048) with forward equity returns. Said differently, an increase in the VIX has almost zero predictability (of signaling) that the market will be higher in the future. A takeaway is that longer-term investing decision making should not be based on the current level of the VIX. Another refrain we hear from the markets is that “the VIX is so low, it has to go up,” similar to “the market has rallied for so long it has to correct.” Since the inception of the VIX in 1990, the median “low volatility” run has been 16 days (excluding very short periods of less than five days). The current running period of low volatility exceeds the median, though historically, it isn’t the longest (see Table 1). A low-volatility period is defined here as a continuous run of closing VIX levels below the historic median. More importantly, the frequency of low-volatility periods has increased since 2012 as depicted in Chart 1. Table 1. Low-Volatility Periods for the VIX Rank 1 2 3 4 5 6 7 8 9 10
Start Date 10/15/1992 12/9/1994 4/18/2005 8/16/2004 4/6/1994 7/19/2006 3/17/2014 11/9/2016 2/10/2015 2/26/2013
End Date Number of Days 3/30/1994 368 3/8/1996 314 5/22/2006 276 4/15/2005 168 11/23/1994 161 2/27/2007 152 10/9/2014 144 5/25/2017 135 6/29/2015 96 6/12/2013 74
Source: Bloomberg, 5/24/17
In addition to these longer, more frequent periods of low volatility, a further complication to the VIX is the speed of reversion of the index. Since 2011, the number of days that volatility remained elevated following a spike has declined (Chart 2). As Chart 3 shows, once volatility jumped on May 17 following headlines regarding potential presidential impeachment, a professional investment manager had just over two trading sessions to try to capitalize on the move.
4 Correlation measures how two asset classes or investments move in relation to each other. The correlation coefficient ranges between -1 and +1. A value of 1 represents perfect positive correlation (as one investment moves, either up or down, the other investment will move in alignment, in the same direction). A correlation coefficient of -1 implies perfect negative correlation (the investments move in exactly opposite directions).
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 3 of 5
Global Investment Strategy—|—Volatility Hasn’t Been Around Here Lately—|—May 30, 2017
Chart 2. VIX Reversion: Days to Recover from Significant Spikes 14.00 13.50 13.00 12.50
Days
12.00 11.50 11.00 10.50 10.00 9.50 9.00
Sources: Bloomberg, Wells Fargo Investment Institute, 5/24/17. Chart shows 30-day moving average of days to Z-score reversion (for the VIX). A spike in this context was measured as a 30 day Z-score break equal to or greater than 2.0. Reversion was then marked as next point at which the Z-score crossed back over zero. A significant spike is an increase in the VIX by at least two standard deviations over its historical mean. The calculation here is shown as a 30-day moving average, in order to see tendencies better. Z-score is a numerical measurement of a value’s relationship to the mean in a group of values. A positive value indicates the score is above the mean and a negative indicates it’s below.
Chart 3. VIX Closing Level: May 2017 (to date) 18 17 16 15
VIX Index
14 13 12 11 10 9 8
VIX Closing Level
Source: Bloomberg, 5/25/17. Data is daily from May 1, 2017 through May 25, 2017. © 2017 Wells Fargo Investment Institute. All rights reserved.
Page 4 of 5
Global Investment Strategy—|—Volatility Hasn’t Been Around Here Lately—|—May 30, 2017
Investment Implications The financial press loves to talk about the VIX since it simplifies stock market volatility in a single number. If you say “fear gauge,” many investors understand the concept, while not understanding the true meaning. Certainly, the VIX is useful for understanding the state and behavior of U.S. equity-market volatility. Effectively hedging a portfolio’s equities requires tailoring the potential solution– whether it’s a diversified portfolio or a concentrated single-stock position. We recommend that investors remain broadly diversified at their target allocations—and focus mostly on those equity sectors likely to benefit from a continuation of the recovery. We are overweight the Consumer Discretionary, Industrials, Financials and Health Care sectors. We do not recommend getting overly defensive—and therefore, we currently are underweight the Consumer Staples and Utilities sectors. We also continue to recommend an underweight position in the Energy sector due to very extended valuations.
Risk Factors Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations.
Definitions Chicago Board Options Exchange Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market. An index is unmanaged and not available for direct investment. Call/Put Options are a contract that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specific price on or before a certain date.
Disclaimers Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company. The information in this report was prepared by the GIS division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 0517-05469
© 2017 Wells Fargo Investment Institute. All rights reserved.
Page 5 of 5
