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Question of the Week - June 26, 2017

Question of the Week - June 26, 2017

Guest Post - Monday, June 26, 2017

Why is market volatility still so low?

Volatility usually drops during the summer months, as trading desk activity slows down along with vacations picking up, etc. (although Americans don't usually take the month-long European variety that occur around August). This year, however, the low vol started earlier, and there does tend to be a connection between bullishness and lack of volatility. Markets tend to rise in a much more tempered pace compared to declines, which often occur in sharp, unpleasant spurts. That mathematical relationship alone explains why the VIX index tends to stay lower in a rising market and rise sharply in a falling one.

The VIX, as a reminder, is the implied forward 30-day standard deviation on the S&P 500, as implied by a common pricing model for call options. From a historical standpoint, the current VIX level remains near its all-time low. The VIX was formally introduced in 1990, so offers us a bit over 25 years of market data to review. As seen in the chart below, the long-term average reading for the VIX is 19.5%, which happens to be a few percentage points above the actual realized weekly volatility of the S&P over that span (closer to 16-17%). In other words, market participants have generally assumed more volatility going forward than realized in the recent past.

Realized volatility has also been running at low levels, with the year-to-date weekly S&P vol running at just over a third of its historical level, and in the lowest percentile ranges of the past 50 years. Interestingly, the low vol has not only been seen in U.S. equities, but also in other regions such as European and Japanese stocks, as well as other assets such as foreign exchange, credit and rate volatility in fixed income.

There are two sides to bullish market sentiment, of course—the presence of positive influences and the removal of negative ones. On the plus side, several key metrics have been running at decent levels, including slightly higher global growth, improved earnings and a paced removal of central bank accommodation has led to an improvement in sentiment and corresponding risk asset prices. The election of Trump and aftermath created a mixed message in that hopes for fiscal/tax policy improvement waxed and waned with congressional debate, while broader fears of other populist leaders globally taking hold were considered a negative influence on sentiment. For instance, the Global Economic Policy Uncertainty Index, which measures media articles about economic uncertainty, and is GDP-weighted for 20 nations, has been at elevated levels throughout the year. Geopolitical concerns appear to be higher, but are outweighed by more tempered financial concerns at this point in the cycle.

Where do we go from here? Bouts of low volatility tend to beget stretches of the same; that is, until it doesn't. Financial conditions remain accommodative, inflation remains benign, and earnings growth has turned positive. For this reason, as well as a lack of 'excesses' in the current business cycle, some economists have marked the chances of a recession at perhaps around one-in-four, or lower than that of prior cycles.

Low Market Volatility Chart

Source: Yahoo! Finance data, FocusPoint Solutions calculations.

Read our Weekly Review for June 26, 2017.

Read the previous Question of the Week for May 8, 2017.

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