(from our Weekly of 21st February)

As we have been noting, the market remains in a risk-on regime, with positive momentum,
falling volatility and confirmation from various inter-market relationships such as cyclical
stocks outperforming high dividend stocks, high yield outperforming investment grade, FX carry trades outperforming, and so on. In such an environment, going outright short equities is very challenging, although we are seeing a some warning signs.

Nevertheless, the extreme levels of complacency priced into option markets does offer very
cheap downside protection as an overlay to long beta positions. The left-hand chart below
looks at the term structure and skew of various equity indices relative to their 3 year history, with a higher Z-score indicating more complacency. We can see that most of the DM indices are at somewhat complacent levels, but the Russell 2000 index is by far the worst.

The right-hand chart uses previous instances where the Z-score for the Russell 2000 index
was greater than 1.0 or less than -1.0 to generate sell and buy signals. We can see that
although there can be false signals, the sell signals are usually followed by a month of sideways or down price movement.

(Click on image to enlarge.)