Cumberland - Markets, SKEW-VIX Ratio

David R. Kotok, Chairman and Chief Investment Officer
August 6-7, 2014
The ratio between the SKEW and VIX is a ratio of two different indices that measure option premiums. Those premiums give indications of market-based pricing of risk. When the SKEW-VIX ratio widens, it says that out-of-the-money options on American stocks are being bid up for the purposes of insuring against tail-risk events. Tail-risk events are higher-volatility swings, that is, swings that could be greater than one or maybe two standard deviations. History suggests that wide ratios between the SKEW and VIX result in market reactions that can be serious. That is why we watch the SKEW-VIX ratio. We give a hat tip to the analysts at BCA Research, who have discussed this in great detail in their work.
We have taken the SKEW-VIX ratio, plotted it against the S&P 500 Index, and put it on our website for readers to see. The data starts in 2008. The ratio and the performance of the US stock market for the entire period of the financial crisis and subsequent rally can be seen. Look at it and draw your own conclusions. Here is the link: http://www.cumber.com/content/misc/SKEW-VIX.pdf.
As this commentary is written, we still maintain a cash reserve and a defensive structure in portfolios. We think there is a still-evolving “fog of war.” We think that risks are rising for accidents, military interventions, and damage to economic recoveries. The world appears to be a very dangerous place.
At the same time, we think that the central banks of the world are out of bullets when it comes to additional assistance in case there are shocks. The zero interest rate policy (ZIRP) around the globe has suppressed volatility for a long time. SKEW-VIX suggests that volatility may be returning.

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When "buy the dips" becomes "sell the rallies,” it is time to re-examine your view of the world.
 
Starting in the second half of this year, the stock markets in the US have changed. What was a long-term upward trend of five years has recently become a series of questions, in a climate characterized by rising uncertainty, added volatility, and greater risk. All these factors are discussed in detail in the new book.
 
Starting in 2009, a large infusion of central bank-created liquidity fueled an improving outlook for economic recovery, which in turn spurred rising earnings expectations and higher stock prices.
 
But now the long-market party from 2009 to 2014 has segued to a period of rising uncertainty. During the bull phase, the short-term and shallow corrections that led to subsequently higher stock prices on the rallies became the norm. The VIX measured this activity and declared it "complacency."
 
The emerging dynamic, on the other hand, reflects concern about what happens when the Federal Reserve (Fed) comes away from the zero bound. What happens if the economic circumstances we have seen in recent years – the favorable breezes of gradually increasing growth, low inflation, no credit events, and no exogenous shocks or geopolitical risks of other types besides simple economics – shift to the gustier headwinds of a more troubled time?
 
We measure this "tail risk” with the SKEW. Note that the SKEW–VIX ratio recently reached a record high. According to BCA Research (July 2014), SKEW pricing can reveal a rising probability of a "two standard deviation move." BCA suggests that the time horizon for such an event could well be within the next three months. We don't know for sure, of course; but the correction so far is over 5% and has broken through serious market levels.
 
To complicate matters, geopolitical tensions have risen in many places worldwide and now pose significantly greater risk. Think about what happens if Vladimir Putin prohibits flights over some of the territory under his jurisdiction. Or consider the ramifications of a tank’s crossing the Russian border into Ukraine. Or think about what happens if a radical Islamic faction explodes a hydroelectric dam in Iraq.
 
This is a dangerous world, and the markets sense that. At the same time, they are aware that the central banks' paths are not easily alterable. Think about the response function of the Fed to an extraneous shock. It cannot readily alter the tapering course it has set. It will be going to neutral.
 
On the other hand, the European Central Bank has only one direction to go: stimulative. It faces a complex array of issues, and its foot-dragging may sink Europe into a full blown recession. Japan is likely to undertake another round of quantitative easing in the fall. The United Kingdom is in the throes of trying to extract itself from its former policy structure.
 
In short, the world is no longer on a consistent, zero-interest-rate, QE path. Instead, the world is divided, and policy is ill-equipped to deal with mounting uncertainties.
 
All of the above add to volatility in the market. For years now, in the US and elsewhere in the world, central banks have used zero interest rates to suppress volatility, creating a false sense of complacency. When markets anticipate the ending of a zero-interest-rate policy, volatility rises. We see this happening in the months of July and August. The concern is that we will see more volatility before this transitional period has run its course.
 
As this commentary is written, we at Cumberland maintain a high cash reserve in our US exchange-traded fund managed accounts. We watch the SKEW and VIX daily.