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(Editor's Note: Steven Sears, our regular options columnist, is out of the office. Today's guest columnist is Jim Strugger, the derivatives strategist with MKM Partners.)
It's the time of year for all manner of prognostications, so here we chime in with our outlook for equity volatility in 2011.
We believe the high-volatility regime that began in July 2007 will remain intact for at least the 5.5-year average duration of prior cycles over the last 25 years.
This implies a minimum of two more years with a floor under the CBOE SPX Volatility Index (VIX) around 15, which has not been breached since the current regime began. We expect intermittent volatility spikes to be staged from this level, though we believe waves will normalize going forward, following the Fall 2008 main shock that spiked spot VIX to 86 and the subsequent aftershock in May of this year, with peak amplitudes reverting toward the 30 average that prevailed prior to the 2008 super-spike.
Equity volatility in the prior two economic cycles transitioned from high to low regimes (defined by spot VIX being range-bound between 10 and 20) at the same time as, and two years following, the respective recession troughs. This suggests a linkage between the business cycle and equity volatility. Our outlook for the current cycle translates into a low-volatility regime beginning in mid-2012, at the earliest, three years following the June 2009 recession trough. Although this implies a longer-than-average period of heightened volatility during the early expansion phase of an economic recovery, the magnitude of the global financial crisis and its still-resonating repercussions have created an environment of elevated risk that we expect to inhibit equity market psychology from easing into a low-volatility regime.
Importantly for us, a period of high volatility and an upward-trending equity market are not mutually exclusive. The S&P 500 Index (SPX) gained 22%, on average, in the 18 months preceding the start of Fed tightening in 1994 and 2004. We believe a similar sweet spot lies immediately ahead, supported by real U.S. GDP growth that MKM Partners Chief Economist Michael Darda pegs in the 3%-4% range and equity valuation that is historically inexpensive with the SPX at 13 times consensus 2011 earnings. As a result, we expect the remainder of the current high-volatility regime to occur against the backdrop of a strengthening U.S. economy and an upward-biased equity market. Of course, given our outlook for volatility, we expect this relatively sanguine environment to be punctuated by periodic shocks that measure between three and six months trough-to-trough and drive spot VIX toward 30 coincident with moderate equity-market corrections.
With the current troughing of equity volatility bringing to a close the wave that began in April, we expect the next shock to occur with a 15-handle on spot VIX sometime in early 2011.
In advance of that event, we recommend deploying a few options strategies: 1) Buying puts outright against long stock positions to hedge gains and exploit low implied volatility; 2) creating costless collars around long positions in February or March 2011 tenor to exploit skew that has flattened coincident with the decline in implied volatility; 3) closing long stock positions, particularly those that sport significant unrealized gains, and replacing them with calls or call spreads to maintain exposure while significantly reducing capital at risk; and 4) initiating long volatility exposure utilizing VIX options or newly introduced exchange-traded fund (ETF) and exchange-traded note (ETN) volatility products. Given our outlook for 2011, we believe all of these represent prudent strategies for equity portfolios.
Comments: steve.sears@barrons.com
http://twitter.com/smsearsBarrons
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