Inside Volatility Trading: The Impact of Grouping

Kevin Davitt

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March 23, 2021

Lifting my head…Looking for danger signs

Talking Heads - Crosseyed and Painless

Grouping is a common strategy to analyze (quantitatively and qualitatively) segments of the population, subsets of the market (sectors) and other disparate entities with similar characteristics. As a species, humans have thrived in no small part due to their ability to group information and work toward common goals.

Sociologists have constructed loose grouping models for Americans based on birth year and the defining historical moments for that group. Technological advances and the economy have played significant roles in the formation of the groups and their associated characteristics. In short, generations are forged by catalysts of macro volatility. Examples include:

Silent Generation (1925-1945): Great Depression and WWII. Automobiles and aircrafts.

Characteristics: Disciplined, self-sacrificing, traditional and cautious.

Baby Boomers (1946- 1964): Post-War boom. Civil Rights Era. Vietnam. Economic prosperity.

Characteristics: Challenge traditional mores, distrust in institutions – particularly post-Nixon.

Generation X (1965-1979): Rise of American hegemony. Fall of the Berlin Wall. Personal computers. Increasing divorce rates.

Characteristics: Skepticism, self-reliant.

Millennials/Gen Y (1980-1995): 9/11 and War on Terror. Internet and Smartphones.

Characteristics: Self-confident and ambitious.

Centennials/Gen Z (1996-TBD): 2008 Financial Crisis, Rise of AI. COVID-19. Digital independence.

Characteristics: Pragmatic, politically progressive and entrepreneurial.

I’m what sociologists might refer to as a “cusper.” For the purposes of a volatility-focused missive, that means I was born in the late 1970s and my professional life began during the tail end of the late 1990s booming stock market.

My start on the Cboe trading floor came in late 1999. Equity markets, particularly technology names, were ripping higher. Firms were tapping public markets at a record clip with IPOs garnering massive attention. The tech heavy index doubled during the final year of the decade-long bull run.

Being a part of the mania (identifiable only in hindsight) was exhilarating, and it’s left an indelible imprint on my psyche. This is purely anecdotal, but the current period has some characteristics that remind me of the late ‘90s and early 2000s. There has been plenty of ink spilled already drawing comparisons between the two periods, much of which is little more than clickbait.

Let’s focus in on a couple of specific trends that may be running in parallel.

Margin Debt

Margin debt is the obligation that investors/traders assume when borrowing funds from a brokerage firm and trading on margin. The alternative to using margin debt is having a fully funded account. According to Reg T, the maximum amount of borrowed capital is capped at 50%. Margin debt can improve return on investment (ROI) if the account balance continues to improve. On the flip side, if investments decline in value, margin can exacerbate losses and lead to forced selling.

In my experience, excessive margin is almost always part of the narrative when the rising tide of a bull market recedes. Here’s a look at the yearly change in margin debt (billions of dollars) according to the NYSE dating back to the mid-1990s.

Margin Debt Yearly Change

Source: Yardeni Research

Clearly, market participants have embraced margin debt over the past 52-weeks. The trajectory of the increase is without comparison. You may notice large builds in margin debt levels during the late ‘90s and in 2007. All else equal, leverage of this type is wonderful when things work well but a nightmare if/when markets move against your position.

In other words, margin has a history of being a catalyst for future volatility.

IPO Market

We are less than a quarter of the way through 2021 and at least 325 companies have already gone public in the United States. Many of the firms brought to market over the past year have done so via Special Purpose Acquisition Companies (SPACs). This time last year, only 37 companies had IPO’d, which illuminates a related point.

Company founders, venture capitalists and the underwriters prefer to bring entities public during favorable market conditions. In the first quarter of last year, there was massive uncertainty about the nascent pandemic and financial conditions were much tighter. You’ll also notice that there was a rush to market for firms in the late ‘90s and middle part of the 2000s followed by collapsing IPO markets in 2001 and again in 2008/2009.

Number of Initial Public Offerings (IPO) by Year in the U.S.

Source: Statista

Over the past four and a half months, more than $465 billion have moved into the global equity markets. There was a smaller but similar deluge of global equity flows in late 2017 and January of 2018. As mentioned in the previous Inside Volatility Trading newsletter, 2017 in U.S. markets was a halcyon period where the S&P 500 Index continued to grind higher with very shallow pullbacks. That trend reversed in short order in early February of 2018.

Weekly Global Equity Flows

Source: Bank of America Investment Strategy

In fairness, these flows are not all domestic. Monies have been moving into equities around the world. For instance, South Korean retail investors, known as “Ants,” are investing aggressively into U.S. stocks recently, representing up to 80% of their holdings in some cases. These flows have been in part aided by fiscal stimulus both on our shores and internationally. It remains to be seen whether this capital is resilient or more transient.

What’s it Worth?

Valuation metrics, like a price-to-earnings (PE) ratio, are insightful tools for investors because they show what the market is willing to pay for a stock based on expected earnings. A PE ratio is calculated by dividing a stock price by its annual earnings per share (EPS). The same technique can be applied to broad-based equity indexes, like the S&P 500 Index.

The chart below illustrates the S&P 500 Index forward PE ratio over the past 25 years. In other words, the current S&P 500 Index level is divided by earnings expected over the following 12 months. Based on current levels, the only comparable period is the late ‘90s and measures are more than a standard deviation over the mean (16.62x).

The S&P 500 Index forward PE ratio in March of 2000 was 27.2x. In October of 2007, that measure was a much more pedestrian 15.7x (earnings were forecasted to be very strong in 2008 – oops). The forward PE ratio is now 21.4x.

S&P 500 Index: Forward Price-to-Earning Ratio

Source: J.P. Morgan Asset Management

Might Makes Right?

The concentration of market cap in the S&P 500 Index on the part of its top 10 stocks recently surpassed levels last seen in early 2000. Back in the early part of the millennium, companies that exerted the greatest sway were Microsoft, General Electric, Cisco, Exxon, Walmart and Intel. Today, it’s still Microsoft alongside Apple, Amazon, Facebook, Alphabet, Tesla and Berkshire Hathaway.

In March of 2000, the top 10 S&P 500 Index constituents made up 27.6% of the index. Today, the top 10 make up 28.1% of the weighting. That’s not to say the broad market can’t continue to move higher. It’s simply an atypical concentration in just 10 companies.

Higher for Longer

As was mentioned in a previous Inside Volatility Trading newsletter, the VIX^® Index broke its nearly one-year long streak closing above the 20 level last month. There have been two more VIX Index closes below 20 since. There’s a school of thought and supporting empirical data that argues for strong equity performance after prolonged periods of high expected volatility as measured by the VIX Index.

One could also argue that volatility clusters. Periods of higher volatility tend to be followed by more volatility. The 20 level in the VIX Index is arbitrary, nevertheless, it’s noted on the chart below. During the late ‘90s, the VIX Index measuring below 20 was the exception, not the rule. For much of 2007 and early 2008 prior to the breakdown in global markets, the same could be said.

The VIX Index 1990-Present

Source: MacroTrends

The VIX Index as well as the VIX futures curve has been reflective of an options market that’s pricing significant future uncertainty. For months, the middle and back of the VIX term structure has been trading 25+. That continues to be the case today.

Simply Put: The Greeks

Introducing Simply Put. In this new section of Inside Volatility, we attempt to demystify and simplify derivatives concepts and topics to empower your understanding and catalyze your application of the concepts.

The Greeks:

The Greeks are risk management tools that measure sensitivities impacting the price (theoretical value) of an option. They are referred to as the Greeks because pricing models’ equations use the Greek letters for Delta, Gamma, Theta, Vega, and Rho to represent those specific sensitivities.

Think of the Greeks like a car’s dashboard. The dashboard gives you vital information on specific risks to which your car may be exposed. For example, the speed while driving, when your car is low in gas, needs an oil change, and the temperatures in- and outside. The Greeks do the same for an options portfolio.

Delta: measures an option’s price sensitivity to changes in the price of the underlying security. Delta is positive for calls and negative for puts.

Gamma: measures an options’ price sensitivity to changes in Delta. Gamma is always positive.

Theta: measures an option’s price sensitivity to time-decay as the option approaches its expiration date. It is always a negative value.

Vega: measures the option’s price sensitivity to changes in the implied volatility of the option.

Rho: measures the option’s price sensitivity to changes in the risk-free interest rate. Central banks control how and when the interest rate changes.

Odds & Ends

The frenzy of retail call buying (mostly) is ongoing. The demand for out-of-the-money (OTM) calls in single name equities has bled into the index option marketplace and altered skew readings for the better part of the past year.

Options skew is measured in a variety of ways in an effort to quantify the relationship (in price or volatility terms) between OTM calls and OTM puts with the same expiry.

The combination of concentration (market cap) atop the S&P 500 Index and technology focused indices, plus significant demand for OTM call options (also focused on largest names) has altered the relationship between OTM calls and puts in Index products since late March of 2020. The question becomes if/when index option skew flattens further, or perhaps steepens, if demand for small delta calls taper off or demand for protective puts increases beyond current levels.

20-Day Moving Average Call Options Skew

Source: Bloomberg

The New Smart Money?

Thus far in 2021, individual (retail account) investors have made up 23% of all equity trading in the United States. On a handful of days, this demographic constituted a third of the total market footprint. Based on the data gathered by the Financial Times, it means that retail trading is equivalent to the impact of all hedge fund and mutual fund trading combined this year. They trail only high-frequency/market-making operations at present.

Market Share of Overall U.S. Equity Trading Volumes

Source: Financial Times

Data indicates that a significant portion of these retail traders are new to investing. They skew young (35 and under), use social media platforms for idea generation, and have embraced optionality (leverage).

Twenty years ago, the retail trader was older and generally had a greater pool of investable assets. They may have used a Yahoo Finance chat board or an “exclusive” newsletter to source investment ideas and advice. They did not use derivative tools with the same frequency seen presently.

Will the advent of commission-free trading platforms, better technology and fractional shares make it different this time? What impact, if any, will a shift away from Work-From-Home and less government stimulus in the future have on trading volumes?

Unusual Divergences

Dow Jones Industrial Average and Nasdaq Daily Closes Since 1986

Source: Bloomberg/Twitter: @jessefelder

During a couple of recent sessions, the technology-heavy Nasdaq has been down 2% or more and the “blue chip” Dow Jones Industrial Average has been higher. That’s highly unusual and indicative of increased dispersion. The shift away from growth names and toward value has been most acute during those days. It’s one more similarity between the current timeframe and the early 2000s.

The generation of investors introduced to capital markets in the late ‘90s may recognize some similarities in the current zeitgeist. The number of (unprofitable) companies going public, short-term and active retail traders, a technology focus, and speculative behavior including the use of margin harkens back to March of 2000.

Here and Now

To what extent are overall expectations detached from reality, or the likely future reality? Groups of incredible humans have worked together to combat a deadly, invisible enemy. This generation’s defining battle isn’t against fascism, the spread of communism in south east Asia, nor the amorphous war on terror. The enemy ranges from 70 to 90 nanometers. It’s smaller than a red blood cell or a dust particle. It’s way smaller than a single human hair.

Victory on the scientific front appears within our grasp. Will one of the byproducts be (multiple) asset bubbles? There’s no vaccine for that one!

Facts all come with points of view

Facts don’t do what I want them to

Facts continue to change their shape

I’m still waiting

Talking Heads - Crosseyed & Painless

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