Volatility Recedes – Temporarily?

With the most recent financial panic receding into history, volatility is returning to more normal levels. This can present opportunities if you believe that the core reason for the panic still exists, but has temporarily faded from the spotlight.  

 At their most basic level, panics are a stampede into cash, and no asset class, regardless of their rationale or quality, is immune; de risking is a brutal, bloody process. In risk management terms, correlations between asset classes and individual instruments converge to 1.0, meaning that they all start moving in lockstep. Since portfolio diversification is therefore reduced, risk metrics increase, which leads to even more selling as risk limits and targets are breached. Eventually, the market runs out of sellers and stability returns.  

 Although painful, there is an upside to panics: the initial and most violent stage almost always runs out of steam after a few days or weeks. Intermittent rallies and pauses then occur, driving volatility levels back down to more normal levels.  

 Tesla’s (TSLA) most recent action is a great example of this. As you undoubtedly know, TSLA has been in liquidation mode since Elon Musk became prominent in the new administration. Tesla then became a symbol of the administration’s policies and a lightning rod for those who disagree. Like all political, social, and economic trends, Tesla hatred can’t go on forever and will diminish over time. As Mr. Musk’s fades from making headlines every day, selling pressure should be relieved.  

 TSLA has been going roughly sideways since early March, and bottomed out (along with the rest of the market) on April 8th. Reflecting this, its implied volatility (see chart below) has plummeted from a high of 101.9% on April 8th to 60.5% on May 2nd, a full 41.4 percentage points lower.  

Putting that into perspective, and holding price, time, and interest rates constant, TSLA options are 40.6% cheaper than at the implied volatility high! You don’t see 40% off sales too often. 

 But…is the panic over, or just in remission? It began due to the massive uncertainty caused by the administration’s ever-shifting economic, budgetary, and social policies. Tariffs are just one example of this. Whatever you think about President Trump, everyone would agree that his one consistent trait is inconsistency. And since one of the main drivers of uncertainty is inconsistency, is it shortsighted to think that uncertainty as a bear market driver won’t come back with a vengeance? Or have the markets just gotten used to it?  

 The Economic Policy Uncertainty Index (https://www.policyuncertainty.com/index.html) may help us find out. Developed by three economics and finance professors, it is constructed from three components – newspaper coverage of economic policy uncertainty, changes to the tax code, and disagreement between economic forecasters. The index is calculated for the US and other countries, as well as for more specialized policy categories.  

The results are clear and indisputable: economic uncertainty is the highest it has ever been, and by a significant margin (see charts below). Whether measured since 1985 using the three components mentioned above, or since 1900 using news articles alone, the results are the same – and shocking. Even if the index were to decline a good amount from current levels, it would still be above the levels recording during the 2000 Pandemic, the 2008 financial crisis, the dot-com bust, and further back, WWII and the Great Depression. If we adjust for possible measurement inconsistencies or methodological errors, current uncertainty levels would probably still be at new highs, and by a large margin.  

As implied by the record-shattering indexes, economic uncertainty will likely remain a feature of the market for some time. As such, the notion that there is a “Trump put” underneath volatility, preventing it from returning to pre-Trump levels, as well as the constant potential for spikes, has some merit.