Despite all the excitement lately, S&P 500 is trading at same levels we saw back in October, May, April, March, February and January. The overall index is trading in a rather big range. The “only new thing” that has occurred, is the fact volatility hit markets hard, and this has continued confusing investors. The Pavlovian investor has got used to extremely low volatile environment, and is finding him/herself relatively “lost”.

The longer-term chart is damaged, but note the bigger trend line around these levels. 2600 is huge and a make or break level to watch very closely should we try that level to the downside. 2700 and then (if) 2800 are the main resistance levels to watch for.

The shorter-term chart below outlines the levels more clearly.

Another “new thing” that has occurred lately, is the fact pretty much nobody mentions the Santa Clause rally. This is one of the few times we have not been hearing about the Santa rally, in late November, for the few decades we have traded the markets. If this is a contrarian sign or not is to be seen, but given the fact pretty much all “smart” investors have been caught wrong lately, maybe the last pain trade of the year will be an “unexpected” short squeeze.

By now everybody on main media is talking about the rise in VIX. We suggested the VIX as the “optimal global hedge” in early October. Much has happened post that note, but the world still exists, and the S&P 500 trades some 8-9% lower compared to early October. VIX has come off from those panic levels, but is still trading relatively “elevated” from the longer-term average. At these levels VIX prices approximately 1.2% daily moves for the S&P index (volatility is proportional to the square root of time).

Main media, including many investors, have limited understanding of volatility as well of VIX etc. Sure, the VIX is a “fear” index, but it is also vital digging deeper into how VIX is trading and what it is telling us. One of those is the VIX curve. In “normal” markets, calm and relatively low volatile markets, VIX trades in a fashion where shorter-term volatility trades lower than longer term volatility (this post is too short to explain it all why, but a bit more to be read here).

Below is a chart showing the spread between 1st month VIX future and the 6th month VIX future (VIX index is just an index and you can´t trade the index itself, only the separate VIX futures).

In calm markets, the shorter dated VIX futures trade “inverted” to longer maturities as can be seen by the chart. In terms of stress, the spread trades positive, i.e. shorter maturities trade higher than longer maturities. Shorter options have more optionality and in terms of stress investors want “quick protection” as gamma is king!

It is vital looking beyond the “simple” VIX index in order to understand what the market really is telling us about how risk is priced. Note that recently the spread has actually come down, despite everything feeling so “bearish”.

With the S&P having come down close to the huge 2600 level and with pretty much every investor felling nervous, having changed from seeing how markets can only go up, to these days all thinking about how to protect the downside (nothing wrong with that, but still a big change compared to only a few months ago), it would be truly ironic to see markets squeeze higher into year end.

Back in early October we argued investors were not paying attention to global macro risks and that volatility was trading way too low. Back then people told us all is fine and that volatility was a sell. Lately these same investors are all talking about global risks and explaining how volatility is here to stay.

Maybe it is time for a contrarian Santa rally set up where equities bounce higher and volatilities come down. After all, the same guys that were awfully wrong and short the VIX in early October have now reversed the aggregate short VIX trade to being actually long VIX (the below chart is somewhat simplified as long VIX futures can be offsetting other short vol positions, but it still paints a “fair” aggregate picture).

VIX net non-commercial futures surging lately.

Source; charts by Bloomberg