Monday, 3 June 2013

Equities - Defensive versus Cyclicals, a volatility update

"Winning takes talent, to repeat takes character." - John Wooden 

Following the rise in volatility in May leading to a strong sectorial rotation, please find below an update on the derivatives markets for 4 emblematic sectors:
-ETFs Healthcare and Consumer Staples for the "defensive" sector (XLV & XLP)
-ETFs Consumer Discretionary and Industrials for cyclicals (XLY & XLI)

Chart 1 : Volatiliies 1 year ATM (At The Money) for XLV & XLP versus XLI & XLY:
- chart source Bloomberg

Chart 2 : Spread Volatility 1 year ATM XLI (Industrials) vs XLV (Healthcare) - source Bloomberg:

One conclusion can be reached from the above is that spreads for long implied volatilities for  the cyclical sector as well as  the defensive sector have touched the lowest levels seen in the last couple of years.

Are the equities derivatives markets pricing correctly or incorrectly the end of the paradigm "min-variance / low-volatility " of the defensive sectors? 

The impact in terms of sectorial allocation based on historical VaR models could be significant should the convergence between historical/implicit volatilities of the sector continue its trend.

In Europe, there is a similar situation going on if you look at for example the volatility for a defensive index such as the SMI versus the volatility of a more cyclical index such as the German DAX.

Chart 3 : Spread 6 months at the money (ATM) volatility for the German DAX vs SMI, source Bloomberg:

Chart 4 : min-var sector valuation premiums (source Barclays):
"Premium for safe, low volatility sectors in Europe looks high. This level was last seen in March 2009 and June 2012". - source Barclays.

So, are implicit volatilities pricing correctly or incorrectly a shift in this paradigm? 

Or are the excess valuation premium anticipating a sudden surge in risk aversion which has not yet been seen yet in long-dated volatilities? We wonder...

"Isn't life a series of images that change as they repeat themselves?" - Andy Warhol 

Stay tuned!

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