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Trading  | June 5, 2018

If there is one thing traders have learned from the past decade, it is that the VIX, or “fear” index as it is still incorrectly called in various financial outlets, has become especially meaningless when measuring market nervousness whether because it is manipulated outright (here, here and here), due to anticipation of central bank intervention following every market crash drop keeping a lid on volatility, or simply because we live in a world in which even the algos have realized the tail wags the dog (with lots of leverage) and instead of buying risk assets, they are selling volatility futures instead.

Furthermore, as Goldman recently explained, the increasingly erratic moves in the VIX are an indication not only that “something is not right”, but that “liquidity is the new leverage” in a world in which central banks and HFTs have soaked up all liquidity precisely when it is most needed.

Recall what Goldman said two weeks ago:

One conspicuous consequence of post-crisis evolution is that trading volumes in many markets are now dominated by high-frequency traders (HFTs). While bid-ask spreads and other indicators of trading liquidity appear to indicate liquidity has improved in markets where HFT has grown, the quality of this liquidity has not yet been stress-tested by recession. The recent experience of the “VIX spike” suggests there is good reason to worry about how well liquidity will be provided during episodes of market distress, and this is only the latest example of a “flash crash”. Regulators and researchers increasingly warn that HFT strategies can contribute to breakdowns in market quality during periods of distress.

As for those macrotourists who still diligently explain to anyone who bothers to listen how central banks have little impact on risk assets, and thus the VIX, and how the record low VIX is the result of decimalization, best of luck with that.

But while VIX may have become an irrelevant byproduct of a manipulated market, there is one indicator that shows just how increasingly jittery, fragile and prone to sudden bouts of liquidation the market has become: price action itself.

Consider the following ratio of S&P returns on down vs up days.

According to Bank of America’s equity derivatives team, so far in 2018, the ratio of the average return of the SPX on down days relative to up days is 1.20 as losses on negative days average 0.89% and gains on positive days average 0.74%.  Just like the trending level in the VIX (which however is doing its best to revert to its 2017 pattern) this marks a sharp reversal from 2017, when the average ratio was 0.83 (the 5th lowest of all time) amid the low vol, lack of any significant drawdowns, and extreme buy-the-dip mentality resulting in higher vol to the upside than the downside.

Call it the market’s “nervousness” indicator, or the willingness to sell stocks at the smallest hint of trouble, coupled with an increasing reluctance to ramp higher.

Another way of observing this ratio divergence is shown in the following Bloomberg chart:

But if in 2017 the ratio was almost an all time low, 2018’s average down/up return ratio is one of the highest on record, the largest we’ve seen since 2008, when the ratio was 1.21.

Not surprisingly, the higher this ratio, the more susceptible the market – and broader economy – are to major upheavals. For reference, the all-time highest level recorded was in 1940 (1.66) at the start of WWII, while the second highest just over 1.40 was in 1929/1930, just in time for the Great Depression.

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