With levels of near-term volatility dropping to levels not seen for almost 25 years, some are beginning to worry whether investors have become more complacent about the risk of any major directional change in the index.
Volatility, represented by the CBOE Volatility index (VIX) and based on S&P 500 stock index option prices, has fallen to levels not seen since 1993.
Some market watchers have suggested that the drop-off suggests the S&P 500 – and markets more generally – could be due a shift after rising steadily over the past year.
Performance of S&P 500 over 1yr
Source: FE Analytics
Michael Baxter, economics commentator for The Share Centre, said: “Since the index was launched in 1990, the average reading has been 19.5. The index peaked in 2008 with a reading, at close, of 80.06, and closed at 42.99 on 10 August 2011.
“However, over the last 12 months or so, volatility has been low, with mild exceptions during the EU referendum and US election. The index closed at 25.76 on 24 June last year – a 12-month high – and also rose over 22 for 24 hours or so a few days before the UK election.”
“The index, which is taken from a moving average of the S&P 500, is often referred to as the ‘fear index’ – implying that right now the markets are very unafraid.”
Erik Knutzen, chief investment officer of multi-asset class portfolios at asset manager Neuberger Berman, said pockets of volatility have begun to emerge elsewhere in the world, although the lack of headline volatility is likely to have been prompted by a collapse in correlation across sectors and securities.
“Post the financial crisis, stock prices have largely moved in tandem with one another, but this relationship may be breaking down as the Fed nudges rates upward while central banks elsewhere in the world maintain their loose monetary policy,” he said.
“This also suggests that central banks are no longer driving asset prices to the extent they once were.”
Scott Berg, portfolio manager of T. Rowe Price Global Growth Equity fund, said falling volatility “is in part a reflection of some very positive and real change in the global economic environment”, highlighting low interest rates and recovering corporate growth.
He said: “While investors continue to enjoy strong returns from global equities, one nagging source of discomfort is the remarkably low level of volatility being displayed by markets, especially given the uncertainties that remain ahead on the macroeconomic, political and corporate earnings front.
“While more return for less volatility is always a welcome perspective for investors, it is rarely a sustainable backdrop at such extremes.”
Performance of VIX over 10yrs
Source: FE Analytics
However, John Higgins, chief markets economist at consultancy Capital Economics, said recently: “The fact that expected volatility is low does not imply that a sudden move is around the corner.
“The expected volatility of the S&P 500 was low in the mid-1990s, but this did not stop equity prices from rising steadily for years as a bubble inflated.”
He explained: “Expected volatility tends to be informed by the volatility that investors have observed in the recent past.
“Admittedly, expected and historical volatility can diverge when investors are worried about a potentially destabilising event that they know is looming. One example of such divergence occurred ahead of the US presidential election last year. But the divergence rarely lasts long.”
Yet, some investment professionals have asked whether investors have become too complacent more recently as markets have shrugged off some macroeconomic challenges and discounted concerns over the geopolitical environment.
“Are they however, too complacent? While it is true that the global economy seems to be in reasonable shape at the moment, with recent purchasing managers’ indexes showing signs of promise, it may be stretching the truth to say there is minimal uncertainty,” added Baxter.
“It is often said that markets turn at the moment when all but the most contrarian of investors are on the verge of giving up – a bull market turns sour just at the moment when most bears have been converted to holding more optimistic views.”
Making sense of the fall in volatility and what it might mean for markets can be quite tricky for investors.
Ben Kumar, portfolio manager at Seven Investment Management, said the fact that volatility is low does not suggest a market correction is imminent, nor should investors base their decisions solely on what the VIX has done.
“For most investors looking at the VIX it would’ve been a terrible, terrible guide of when to buy and sell if you used that as your only rule of thumb,” he said. “Really it gives you a sense of what’s going on today, rather than predicting the future.”
T. Rowe Price manager Berg says any weakness brought about by an increase in volatility could also present a buying opportunity for its favoured stocks, adding: “Applying the courage of your convictions during times of pessimism has been crucial during this now very long and mostly bumpy bull market. We do not believe this perspective has changed.”
A more diversified approach to investing is more likely to protect investors from any surge in volatility, said Neuberger Berman’s Knutzen.
“We believe investors need to focus on fundamentals and prepare themselves for the possibility of renewed volatility – in other words, to make volatility their friend,” he explained.
“We believe investors can work volatility to their own advantage by diversifying portfolios using volatility-capture strategies.
“These can include income-oriented strategies, which are particularly helpful in a rising interest rate environment. And there are many other tools available that seek to capture return while mitigating risk.”