It’s calm out there. But is it too calm? That seems to be the question many posit with the VIX and St. Louis Fed’s Financial Stress Index hitting seven-year lows. Vanishing volatility has driven the punditry to scramble for eyeball-grabbing headlines—like the odd notion, “Volatility is Crashing.” Near-daily we see these crazy headlines all about that darned low volatility. Folks again are on a quest to find the deeply hidden inner meaning behind all the curiously smooth sailing—attempting to forecast volatility and/or market direction based on past volatility. However, we’d caution about buying into this notion. Volatility holds no predictive power for future volatility or market direction. Volatility simply varies.
Interpretations of low volatility and what it means are all over the map. Some suggest it implies low fear levels, leading to two totally contradictory conclusions. One, that volatility is set to spike back to the mean. Or two, that confidence is rising and, as it does, volatility will remain low even as the bull carries on. Some worry low volatility implies investors aren’t accounting for market risks. Others highlight investors’ constant demand for shares each time the market drops, suggesting the low volatility may be a correction without a short-term dip (seems awfully Pollyanna to us). Some claim we’re back to the “Great Moderation” of low interest rates and muted volatility they claim occurred from 1987-2007. (Though this theory seems to gloss right over a bigger-than-average 2000-2002 bear market, the S&L crisis-led 1990 bear and some pretty major bull market corrections in 1997 & 1998, for just a few examples.) Others draw the same parallel but argue markets are set up for failure due to too “loose” monetary policy or investors dialing up leverage and seeking super-risky bets in an otherwise range-bound, tepid environment. To them, it’s 2006 or 2007 all over again.
But all these contradictory theses rest on the same old fallacy: They hinge on past movement, despite the fact no period of past returns indicates much about the future. Volatility, however you measure it, is backward-looking. Recent trends don’t predict future volatility or market direction. Mean reversion? Great Moderation 2.0? Sideways corrections? They are all forecasts using only the past.
This should become abundantly clear when you consider the logic underlying the various volatility measures cited. The CBOE’s VIX is an effort to forecast the magnitude of a market move over the next 30 days. It’s an average of stock option prices that doesn’t even differentiate between different types of options that could imply opposing direction. But here’s the thing: Markets are pretty darned efficient, and the VIX’s alleged implications are well-known—sapping much of its predictive power. Same for its bond and currency market siblings, Merrill Lynch’s MOVE and Deutsche Bank’s implied currency volatility index. Why would options contracts on bonds or foreign currencies say anything about what happens in capital markets from here? Investors take out contracts based on how they feel—but that’s often a reflection of past performance. Traders see flat-but-bouncy times, traders expect flat-but-bouncy times. And maybe we do get more flat-but-bouncy times ahead! The VIX hovered around its present level for much of 1994-1996 and 2004-2007. But there isn’t anything about the VIX that would’ve clued you in to the staying power of low volatility, so using those factoids to project we’ve entered some mid-bull market period of smooth sailing is faulty forecasting.
As to the St. Louis Fed Financial Stress Index, the mothership that aggregates the VIX, MOVE, yield spread, stock prices and about a dozen interest rates over the past week. Now, some of these individual components have forward-looking value—like the yield spread. But when you lump the few valuable forward indicators with the VIX, the S&P 500, recent bond yields (which the yield spread would already reflect) and LIBOR, it’s pretty clear you’ve got an arbitrary gathering of 18 … umm … things? That’s unlikely to be much more predictive than a single series.
But you don’t need to look at the “volatility” or “stress” gauges to see how calm markets have been lately. Just look at stocks themselves! Since the beginning of the year, we’ve seen only 8 days with S&P 500 Price Returns of -1% or lower (that’s one per every 12 trading days). For scale: the average is typically one per every 8.2 trading days (12/31/1982-12/31/2013). Of the 345 complete quarters since 1927, only 39 had flatter returns than Q1 2014. There have been some ups and downs, but the range is overall very narrow—just some muted bouncing in a slightly higher overall trajectory. There isn’t anything inherently meaningful in this, though—it doesn’t mean we’re seeing some sort of inflection point, reverting to the mean after a big 2013, on the verge of a correction, in for more flat-but-bouncy times or anything else. It’s just markets being markets. Reading into volatility is sheer folly.
Leaving volatility aside, most evidence suggests the bull market likely continues, in our view. In recent months, retail sales, factory orders and the ISM’s services and manufacturing gauges all showed growth continued. The Conference Board’s US Leading Economic Index (LEI) is high and rising, implying US economic growth likely keeps chugging along going forward. Only 3 of the 12 countries The Conference Board publishes LEI for fell in their latest reading (Brazil, Mexico and Japan). A growing global economy is fuel for continued profit growth, and it doesn’t get much more fundamental for stocks than that.
With more bull market, more volatility likely comes too—and that’s a good thing. Many people think volatility equals more drops, but volatility is simply movement. Markets can’t go up if they aren’t moving at all. It’s no coincidence this low-volatility period has come with small returns. Sure, with more movement investors will probably experience more occasional downward wobbles—but that’s just how markets work. Oh, and when those wobbles come, they won’t indicate what comes next.