Stock volatility expectations dropped by a record amount following the French election – in both the U.S. and in Europe.
As with prior geopolitical events over the past 12 months, equity volatility expectations really ramped up prior to last weekend’s election in France. Similar to the Brexit episode and the U.S. presidential election, traders were falling all over each other to add protection in the form of volatility hedges. Like those previous episodes, the stock market action hardly justified such a ramp in volatility expectations. In fact, as we detailed in a series on the VIX two weeks ago, the developments were, in a way, unprecedented given the relatively minor pullback in stocks. Nevertheless, traders apparently thought the election represented significant event risk.
As we saw with Brexit and the U.S. presidential election, though, the considerable volatility hedging necessarily lessened the event risk as it provided a substantial cushion to any potential post-event blow to the stock market. Such a cushion was demonstrated in the immediate aftermath of Brexit and the U.S. election as sharp losses were quickly erased. In this case, the hedges proved wholly unnecessary as global equity markets commenced an immediate a rally after the French election. As such, in a collective sigh of relief, the volatility hedges on both sides of the Atlantic were removed as quickly as they were built up. In some ways, this sigh of relief was also unprecedented. To wit:
In the U.S., Monday saw the largest daily decline (42%), on a percentage basis, in the 6-year history of the 9-day S&P 500 Volatility Index, or VXST.
Similarly, across the pond, the Volatility Index (VSTOXX) on the European STOXX 50 Index experienced the largest daily decline (35%) in its 12-year history.
The above charts display historical drops of similar magnitude in each of these instruments. However, as noted on the charts, there has been quite a variation in the conditions surrounding such drops, i.e., some occurred when the Volatility Indices were quite elevated and others when they were relatively low. At least historically, the prevailing conditions have made a difference in the forward returns in the S&P 500 and STOXX 50.
Our Premium Post on The Lyons Share examines how prevailing conditions have effected the impact of the Volatility plunge on returns in the S&P 500 and the STOXX 50 going forward – and by how much. The analysis may give us a better idea about which way stocks are likely to go following this recent signal. If you find the original research we share here interesting and helpful, we invite you to check out our “all-access” site, The Lyons Share.
Disclaimer: JLFMI’s actual investment decisions are based on our proprietary models. The conclusions based on the study in this letter may or may not be consistent with JLFMI’s actual investment posture at any given time. Additionally, the commentary provided here is for informational purposes only and should not be taken as a recommendation to invest in any specific securities or according to any specific methodologies. Proper due diligence should be performed before investing in any investment vehicle. There is a risk of loss involved in all investments.