Has "worship of stocks" turned into "reverence for bonds"?

The trend started in early 2009. Net flows into fixed income mutual funds began to rise, while equity funds stayed flat. The trend continues through today, although equity ETFs have fared better than mutual funds (see discussion). But even within the ETF universe, flows into fixed income accelerated while equity ETFs grew quite gradually if at all.

Shares outstanding for SPY (S&P500 ETF)  vs LQD (investment grade bond ETF) (Bloomberg).

Given that the corporate bond market is smaller and less liquid than the equity market, that imbalance in growth of cumulative flows has driven yields/spreads to historical lows. Now some analysts are asking if corporate credit is overpriced relative to equities. One way to assess this is by looking at corporate bond yields vs. equity dividend yields.

The spread between the two has collapsed recently. One gets almost the same income holding corporate bonds as buying the S&P500 stocks. Is this the "new normal" according to PIMCO? Has the "worship of stocks" turned into the "reverence for bonds" (which is of course what Bill Gross wants)? Or are we simply looking at a market dislocation?

Source: CS

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Implied volatility distortions for short-dated calls are not real

Someone sent us this Bloomberg chart that shows the SPY (ETF) equity option "skew" (implied volatilities across different strike levels) for options with a 1-month maturity. Strike price is shown as a percentage of the current price of SPY. It looks as though the implied volatility on the up-side has spiked dramatically. One explanation proposed has been that as the equity rally stalled and people have sold some of their equity positions, they also bought back the covered calls they shorted earlier - bumping up implied vols.

1 month SPY SKEW: Today, 3 days ago, 1 week ago

But there is a simpler explanation. The deep out-of-the-money options for a 1 month maturity are quoted at a couple of pennies but there are no trades at these levels. As SPY sold off a bit during the week, the options were still quoted at roughly the same levels and there were still no trades.

Call option quotes (Source: Bloomberg) 

Now if options are "priced" at a constant level while the underlying drops, the implied volatility will increase. When options are quoted in pennies and little or no trading takes place, seeming distortions in implied volatility become common. But it's hardly an indication of anything fundamental going on in the market. With the 3-month maturities for example, where option premiums have real value, this distortion no longer exists.

3 month SPY SKEW: Today and 1 week ago (Bloomberg)

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The steepening vol curve and more risk decoupling

Implied volatility continues to sell off, with VIX down 10% (of vol, not points) month to date. The sell-off is particularly strong for short-dated options as VIX futures curve continues to steepen. The chart below shows VIX futures one-day move along the curve, with the nearby contract coming off sharply.

(Bloomberg)

With bullish year-end calls, we continue to have a case of "cognitive dissonance" as risk indicators diverge.  Surprisingly this time we are seeing the decoupling of the USD swap spreads and the US implied volatility index.  The two-year USD swap spread is up 4 bp today, while VIX is down some 3%.  This indicates further decoupling of short term risks in equities from medium term bank funding risks.

(Bloomberg)

Given that funding risk is generally associated with banks, this divergence is also visible in the underperformance of the financial sector during the past week.  The chart below compares recent performance of XLF and SPY ETFs (financial sector vs. the overall market).

The broad interpretation here would be that Europe's problems may impact US financials, but in the short-term the US equity market risks have diminished.  Again if one disagrees with this fundamental view, this may be a good opportunity to put on a trade: for example long SPY puts, receive fixed on the 2-year USD swap, and short 2-year treasuries. 

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