Morgan Stanley Sees Markets Shifting Focus to Earnings
Hold the financial fireworks: this earnings season is poised to restore tranquility to an equity market that’s been anything but.
The Cboe Volatility Index -- a gauge of the S&P 500 Index’s implied volatility over the next month derived from options prices -- has been running below the 10-day realized volatility of the benchmark for nearly three weeks. One upshot: the earnings season that’s just getting underway is expected to serve as a salve for jittery markets.
A calmer backdrop for equities would bring pain to speculators, or more kindly, reduce the value of their hedges. The weekly commitment of traders report from the CFTC shows non-commercial position in VIX futures rose to a record net long of nearly 93,000 contracts as of April 10, indicating unrelenting bets on continued market turmoil in the face of manifold headline risk. It’s also a contrarian signal for investors hoping that earnings will bring about a relatively more calm backdrop for equities.
“The VIX has started becoming unresponsive to equity market pullbacks, while net positioning in VIX futures is very stretched, at levels that have historically made market bottoms," writes EIA All Weather Partners Chief Macro Strategist Naufal Sanaullah. “At present, we believe the market has a strong setup for climbing the ‘wall of worry’ characterized by the following risks: China trade war, escalation of military conflict in Syria, constitutional crisis in the U.S., and escalation of political backlash to Amazon and Facebook."
Implied volatility typically trades at a premium to realized volatility because of risk aversion and the higher risk assumed by sellers rather than buyers of options. During this bull market, episodes when 10-day realized volatility runs ahead of implied tend to be fairly brief. In fact, the current 14-session streak is the longest stretch in which the VIX has been below two-week realized volatility since 2008.
Traders have two good reasons to think stock swings will settle down. Earnings seasons are often accompanied by a decline in realized correlations -- that is, stocks understandably move for unique reasons related to their individual corporate performance. This effectively leaves single-stock volatility elevated, but depresses it at the index level. In addition, 80 percent of the S&P 500’s gains since 2013 have come during stretches when companies provide these quarterly updates, as corporate results tend to beat analysts’ expectations. The VIX Index typically moves inversely to U.S. stocks.
“It’s normal and expected for implied volatility to come in ahead of earnings because earnings usually do have a dampening effect on realized volatility," said Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors, in an interview. "Straight-line extrapolation is the biggest risk in volatility trading -- both from the long and short side."
However, solid bank earnings on Friday didn’t help shares of that sector or the S&P 500 Index, and the latest season snapped the benchmark index’s streak of 20 straight gains during reporting periods.
Indeed, Wells Fargo Securities head of U.S. equity strategy Christopher Harvey notes that early on, even firms that have reported better-than-expected sales or profits have underperformed the market as a whole. That may suggest it takes more to wow investors this time around, or growing concern that past performance is no guarantee of future results.
"As earning season progresses, we expect volatility to decay with the increased certainty and understanding of corporate fundamentals," he wrote in a note to clients on Sunday.
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