* Five-year low in volatility may not last
* Fiscal cliff, election possible market-moving events
* VIX index options volume sets daily record on Tuesday
By Doris Frankel
Sept 13 A calm summer has allowed many on Wall
Street to take vacations this year, but don't count on the
tranquility lasting into the fall.
Massive central bank intervention has kept a lid on the
market turmoil of the past year, and helped major U.S. stock
indices advance to multi-year highs even as the European debt
crisis remains a threat, and demand slowed in major world
The S&P 500 closed at its highest level since December 2007
on Thursday after the U.S. Federal Reserve said it would start
another round of monetary stimulus to boost the economy. As a
result, risk perceptions reflected by Wall Street's so-called
fear gauge, the CBOE Volatility Index fell sharply. The
VIX dropped 11 percent to 14.05.
The VIX had hit a multi-year low in August and remains below
20, consistent with expectations for relative calm in markets,
compared with the 48 level it hit in August 2011.
But market strategists say more volatile periods could lie
ahead, pointing to macro risks surrounding the uncertainty of
the three-year old European debt crisis, the U.S. presidential
election in November, and tensions between Israel and Iran and
the Middle East in general.
To top it all off, the looming "fiscal cliff" in the United
States - a combination of tax increases and cuts in government
spending that could send the U.S. economy into recession - also
"At the end of the day I don't think we are adequately
pricing in risk right now," said Michael McCarty, managing
partner of Differential Research, an institutional research firm
in Austin, Texas.
In the options market, heading into the Fed meeting heavy
volume in VIX contracts suggested some investors were looking to
protect their portfolios against a potential pullback in stocks
and a spike up in volatility in the weeks and months ahead.
Options volume on the VIX hit a daily record on Tuesday, as
more than 1.2 million contracts changed hands, the highest level
since August 2011, according to the Chicago Board Options
Exchange. That exceeded the previous peak of 1.17 million
contracts traded on Aug. 5, 2011 - the day Standard & Poor's
lowered the U.S. triple-A credit rating to double-A-plus.
The turnover included more than 827,000 VIX call options
traded on Tuesday.
"As volume in VIX options increases, it is a signal that
more people are using the contracts as a hedge to their long
equity exposure," said Ben Londergan, co-chief executive officer
at Group One Trading in Chicago.
Last summer, Wall Street suffered through a sharp selloff
throughout August as Congress and the Obama Administration were
unable to agree to a deal to raise the U.S. debt borrowing limit
until the last minute.
This week, Moody's Investors Service again warned that a
downgrade of the U.S.'s triple-A rating is possible if budget
negotiations do not lead to a meaningful decline in the deficit.
A package of tax hikes and automatic spending cuts are
scheduled to take effect i n December u nless the Obama
Administration and Congress make a deal to maintain certain tax
and spending cuts and let others expire.
Any deal talks will be shaped by November's U.S.
"The reason this will outweigh other macro risks such as the
fiscal cliff and the European crisis, is that the elected
president and his policies can sway the economy. Be it real or
perceived, many will have that as their number one factor," said
TD Ameritrade chief derivatives strategist J.J. Kinahan.
VIX BELOW LONG-TERM MEAN
In mid-August, the VIX fell to a five-year low of 13.45 as
realized volatility for the S&P 500, which tracks the past daily
moves of the S&P 500, also dropped to very low levels. The VIX
is still below its long-term mean of 20.50.
The VIX tracks projected near-term stock market volatility
embedded in a strip of S&P 500 Index options and
generally moves inversely to the S&P benchmark. It has been
below the 20 threshold for most of the last three months as
stocks have advanced.
MKM Partners derivatives strategist Jim Strugger believes
the volatility cycle may have reached a critical point last week
with a number of options market metrics suggesting that the
period of time where the VIX has remained below the 20 level is
in its late stage.
Strugger said this occurred at the same time that the S&P
500 broke above its 2012 high, suggesting U.S. equities will
have a strong move up over the next four to six weeks.
At some point in mid- to late October, Strugger expects the
natural end of the volatility cycle to converge with the
seasonal peak in VIX, driving it sharply above the 20 level.
If a selloff becomes more likely then, investors now have
several choices to protect their positions. McCarty suggests
selling riskier stocks and deleveraging a portfolio, and adding
a volatility asset such as VIX futures and options "to dampen
Equity and quantitative strategists at Bank of America
Merrill Lynch said in a report to clients they saw limited
potential for equity markets to rise further, as the S&P 500 has
already gained nearly 16 percent on the year, nearing their
1,450 target for 2012.
The firm also pointed to the strong historical relationship
between the slope of the yield curve and the VIX. Moves in the
yield curve - the gap between long- and short-term interest
rates - tend to lead moves in the VIX by about two years. The
curve has flattened over the last 18 months, suggesting
volatility may increase in coming months.
Generally, when the VIX rises, BofA wrote that high-quality
stocks tend to outperform, as do defensive stocks such as
healthcare and consumer staples. More volatile sectors like
financials and consumer discretionary shares tend to do worse.
"Right now people are parking their money in defensive
names, and I don't think that's played out," said Mike Shea, a
managing partner and trader at Direct Access Partners LLC in New