June 26th, 2017 | by Gregg S. Fisher, CFA, "Invest with Reason"
Should Investors Fear the Market’s Lack of Fear?
- In the face of persistent political and economic uncertainty, the US equity market has remained notably calm, causing some investors to worry about the apparent lack of worry in the market.
- The VIX (CBOE Volatility Index), a popular barometer of market fear, currently stands at a nearly 24-year low.
- Research conducted by Gerstein Fisher has found that, although the VIX is meant to capture market expectations of future volatility, it historically has done a better job reflecting what has already happened in the market.
- Correlations between the VIX and future returns have, in fact, been found to be negligible, implying that investors would likely do better worrying about things like proper portfolio diversification and sufficient levels of liquidity than the current level of the “fear index.”
The stock market has been unusually calm of late—and that tranquility is making many investors quite nervous. On June 2, the VIX (CBOE Volatility Index) fell to 9.75, its lowest reading in nearly 24 years. This “fear index” has closed at or below 10 many times in recent weeks, a pattern that has occurred only twice before (December 1993 and November-December 2006) since the VIX came into being in January 1990. Investors wonder if this low level of fear is a worrying sign of complacency– and what it implies for future market returns.
Let’s first describe what the VIX means—and doesn’t mean. The index is, technically, a measure of the stock market’s expectation of (future) 30-day volatility. A VIX reading of 10, for instance, means that, according to aggregate options trading, the S&P 500 Index has a 68% implied probability (i.e., one standard deviation) of trading within a plus or minus 10% range over the following year.
There appears to be a heavy behavioral element to the VIX. We find that the VIX is more closely correlated with 30-day trailing, realized volatility (0.89 from February 1990 to May 2017) than with forward 30-day volatility (0.77 during the same time frame). Our research also demonstrates a much higher correlation between the VIX and trailing 30-day S&P index returns than with forward 30-day returns (0.59 vs. 0.43). In other words, the VIX, which tends to lag the S&P 500 Index, is better at informing you what has already happened in markets (and, as we humans are prone to do, extrapolates the past into the future) than what will happen. Exhibit 1 presents a history of the relationship (which is one of, essentially, no correlation) between the VIX index and S&P 500 returns. We have also studied VIX and forward 30-day returns and similarly found no clear relationship.
It’s difficult to state with confidence exactly why market volatility is so low right now, but we can offer some theories. We are in the ninth year of a bull market that began in March 2009; interest rates (both short- and long-term) are still low and monetary policy of the world’s major central banks is quite accommodating; US earnings are rebounding and economic growth, while not strong, is quite stable; overseas growth is picking up; the prospect of lower corporate and individual taxes in the US beckons; and since last November’s election, correlations among the 11 S&P 500 Index sectors have fallen and dispersion of stock returns widened, which tends to dampen overall volatility. Moreover, foreign markets are also exhibiting a similar pattern – expected volatility of the Euro Stoxx 50 Index- as measured by Euro Stoxx 50 Volatility Index– is near an all-time low since the inception of this volatility index in 1999. We have no idea how long the seas will stay calm, but we doubt that this represents a “new normal” of low market volatility. In fact, the history of the VIX shows a pattern of mean reversion, which implies that at some point the seas will become choppier and the VIX will rebound to a higher level.
VIX and Expected Returns
Of greater interest to us than reasons behind the current VIX level and speculating when the tide will turn is what unusually low volatility may portend for future stock returns. One might hypothesize that, since the VIX is typically low when stocks are high, balmy market weather breeds complacency and is ominous for expected equity returns. But our research, dating back to the dawn of the VIX in January 1990 (an admittedly limited time frame for such a study, but this is the longest period available and still instructive), does not bear this out at all. In fact, we find no relationship between the VIX and future returns, and that a lower VIX historically has actually presaged higher expected returns during 1, 5-, and 10-year rolling periods. For instance, for forward 12-month returns, when we divide VIX levels into five quintiles (from lowest to highest), the average 12-month market returns (13%) following the both the highest VIX levels and the lowest were identical (see Exhibit 2). In a similar vein, we see a very low correlation between expected volatility of international markets and forward returns (albeit on a shortened dataset starting in 1999). For example, the correlation between the Euro Stoxx 50 Volatility Index and forward 12-month returns of European equities is only 0.18.
I realize that investors are constantly parsing the tea leaves to spot patterns, but in sum, I don’t think investors should either panic or be too sanguine about a very low VIX level. Just as with an unusually high market level (see Fear of Market Heights), an abnormally low VIX level is one variable for investors to consider but is not terribly predictive of future returns in itself.
Still, this might be a good time for long-term investors to ensure that they’re following some basic principles such as verifying that portfolio allocations are appropriate for their needs and risk tolerance, which includes keeping adequate cash reserves (at least six months of expenses), and that portfolios have been sensibly rebalanced back to strategic asset allocations. Based on an abundance of experience of working with investors, one assertion I will make about a low VIX level is that it is much easier to consider whether current portfolio allocations are appropriate for your long-term goals while the seas are calm than to wait until they become choppy again.