The so-called ’fear gauge’ of Wall Street is currently showing “a complete absence of fear”, leading some commentators to warn that those continuing to buy equities are putting themselves in a vulnerable position.
The CBOE SPX Volatility index – more commonly known as the VIX – is seen as a key barometer of investor sentiment and market volatility. It measures the market expectations of near-term volatility conveyed by S&P 500 stock index option prices; the higher the index the more fearful investors are while a low reading suggests they are not concerned about looming market setbacks.
Over recent months the VIX has been trading at historically low levels and last week it closed at 10.75. This is close to its 23-year low of 9.75 and significantly below its 10-year average closing level of 20.66.
VIX closing level over 10yrs
Source: Chicago Board Options Exchange
Tim Edwards, senior director of index investment strategy at S&P Dow Jones Indices, said the VIX’s currently low reading suggests an “intensely relaxed” market.
“Be it through complacency or prescience, the market is intensely relaxed at present. Most of our volatility measures are down and several to unusually low levels,” he said.
“The sustained low volatility environment has provided a boon to volatility sellers; the S&P Daily Inverse Short Term VIX Futures index has tripled over the past 12 months. In signs that such outsized returns may be attracting more participants, the VIX futures curve is unusually shallow. Only 5 per cent separates the price of the front future from that of the front-next.”
Not all parts of the market are showing unusually low levels of volatility, however.
The BPVIX, which indicates expected volatility in sterling, has been rising in reflecting of political uncertainty caused by the failure to form a majority government and the start of Brexit negotiations.
Meanwhile, Australian volatility measure, S&P/ASX 200 VIX has also risen recently due to signs of a falling property market.
On the whole though, volatility in financial markets is at very depressed levels. James Butterfill, head of research & investment strategy at ETF Securities, warned that this suggests investors are presently too complacent about the risks in markets.
Butterfill noted that the low VIX reading has come at a time when many markets are trading at close to record highs while many risks can be seen on the horizon.
“The VIX index is currently demonstrating a complete absence of fear. In the context of current world affairs and political instability, we believe this is demonstrating a worrying complacency amongst investors,” he said.
“The VIX and equity valuations are unusually closely correlated, implying that investors are buying equities due to their low volatility, and are comfortable with high valuations as a result. As we believe the VIX is likely understating risk, this puts equity investors in a vulnerable position.”
Performance of VIX and S&P 500 over 15yrs
Source: FE Analytics
Butterfill has been concerned by the trend of investors going short the VIX – or those expecting market volatility to fall further – as they can be hit with sudden shocks.
“Since 2013 a worrying trend has arisen amongst a group of investors who are shorting the VIX. The subdued level of the VIX has likely been driven by investors, on the hunt for yield, motivated by years of loose monetary policy. The steep term structure gives these investors who are short the VIX a yield,” he explained.
“According to the Commodity Futures Trading Commission, investors are holding record short positions - over 3x standard deviation from its historical range relative to long positions - suggesting shorting the VIX is an increasingly crowded trade.
“We question how long this can last given the VIX is so low. We also remain concerned that an unwind of this trade will hurt, potentially prompting a VIX short squeeze and the resultant higher volatility prompting a risk asset sell-off.”
Butterfill highlighted the spike in the index on 17 May as a good example of how painful it can be to short the VIX. Revelations that Donald Trump asked ex-FBI director James Comey to drop the FBI investigation into Russian involvement in the US presidential elections caused the VIX to jump 46 per cent from 10.6 to 15.6 overnight.
ETF Securities’ own model of the VIX uses a combination of the Global Financial Stress Index (GFSI) and the US Economic Policy Uncertainty Index, has started to increasingly deviate from the actual VIX. The ETF Securities model suggests the VIX should be trading at close to 16 than its current level.
The low reading of the VIX has implications for more than just those shorting the index. Butterfill notes there has been a poor relationship between the VIX and price/earnings (PE) valuations historically but this has changed more recently.
In the US, the VIX and PEs have had a 0.1 r-squared since 1990 (showing a low correlation to each other) but his has risen to 0.58 over the past two years, suggesting a much closer correlation between the VIX and PEs.
VIX versus S&P 500 price/earnings valuations
Source: Bloomberg, ETF Securities
“The worrying aspect in the relationship is that the further the VIX falls, the higher valuations are, implying that investors are buying equities due to their low volatility, and are happy paying higher valuations to do so. As we believe the VIX is likely understating risk, this puts equity investors in a vulnerable position,” Butterfill concluded.
“In short, we believe equity investors are becoming too complacent, valuations are high at a time when margins are likely to be squeezed further, whilst many promised corporate tax cuts may not come to fruition this year.
“Furthermore, we believe the VIX is lulling some investors into a false sense of security when holding equities. These factors leave equity markets vulnerable to a sell-off in the event of further interest rate rises and continued lack of clarity from the US political administration.”