At the end of 2011, expert opinion on equity markets prospects was so one-sided and bearish with the fear of a disorderly default in Greece, European banks’ insolvency problem and the possible collapse of the Euro system amid the refinancing peak in March and April of 2012. Despite all this one-sided bearishness, the Hang Seng Index, like most of its peers globally, finished the first month of 2012 with more than 10 percent gains and kept up the momentum in February.
The reason we saw the best start to the year since 1991 for Hang Seng Index is that the bearish consensus back then had largely overstated the equity market risks. One way to measure the perceived risk level is to look at the risk premium that equity investors require to gain in excess of US Treasuries. If the risk premium (the spreads between Hang Seng Index’s earnings yield and 10-year Treasury yield) widens, it indicates equity investors demand a higher safety margin to hold equities instead of the risk-free US Treasuries. For the last quarter in 2011, the risk premium mostly remained at an elevated level at above 8 percent, indicating equity investors were very pessimistic. With the one-sided pessimism in the market that already priced in a lot of bad news, the lack of fresh bad news together with various central banks easing policies around the world has buoyed the market by a meaningful margin in a short period of time.
I didn’t anticipate the extent of the current rally in risk assets, but it was well expected that the one-sided bearishness in the equity market could not sustain as other risk proxies, like the volatility index, indicated that the market’s risk level was actually going down instead of up back in December 2011. The volatility index (VIX for S&P 500, VHSI for Hang Seng Index, etc) that measures the implied volatility in the option market of respective equity index is often called “fear gauge” with its sensitivity and inverse correlation with the equity market. Since implied volatility is an important variable in option pricing, the volatility index would normally see a spike amid panic market when investors are rushing to buy protection and bid up the price of put options.
For the first 11 months in 2011, the implied volatility (VHSI) has been closely tracking the Hang Seng Index’s risk premium as both of them are regarded as good proxies for indicating the perceived risk level in the market. However, these two lines decoupled since December, especially after the announcement of the first long-term refinancing operations (LTRO), a funding facility by European Central Bank that lent out nearly 500 billion euro to European banks. The decoupling of the two lines basically reflected the option market was pricing in a lower market risk ahead but the equity market was still reluctant to accept the fact that there was any market improvement.
After two strong months for equities, it is obvious that the option market got the better of the equity market when it hinted a rally back in December with the drop in implied volatility. Indeed, the way we see the recent rally in the past two months is that equities have been playing catch-up and pricing in the improved market sentiment after around a month of delay compared to the option market.
As we reach the end of this quarter, the question for both institutional and individual investors is that how far this catch-up play in equity market can possibly go. With the second LTRO that lent out another 529.5 billion euro, it is hard to imagine what sort of good news to expect moving forward.
In addition, the volatility Index (the VIX Index) demonstrates a strong mean-reverting pattern, which seems set for a rebound as it approaches low end of the range. If history repeats itself with the volatility index leading the equity market, a widening equity risk premium and therefore a weak equity market are expected in the coming months.
Although it is unwise to bet against an up market as it can always stay irrational longer than anyone can stay solvent, adding more risk positions to the portfolio at this point in time seems equally reckless.
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