This guest commentary was written by Mike O'Rourke of JonesTrading.
The New York Fed published an interesting note titled “The Low Volatility Puzzle: Are Investors Complacent?” Coming from the most influential regional Fed bank, such a note merits further consideration. The note highlights market concerns commenting that:
"One argument is based on the simple idea that stock market volatility will revert to its historical mean, with equity valuations dropping while volatility “corrects.” In the past, increases in volatility have been negatively correlated with stock market returns… if the VIX were to return to a “normal” level closer to its average of around 20 percent since 1990, the S&P 500 index might be expected to decline by 5-10 percent.”
The authors caution that the “post crisis regime” may be different and the time frame in which the VIX move occurs are important variables. The NY Fed also warned that:
“If investors respond by increasing leverage, small shocks to asset prices may suddenly make constraints bind, which can force investors to sell assets, raise volatility, and tighten constraints further. This feedback loop creates risk endogenously, meaning that low volatility in itself can be a catalyst for high future volatility.”
We have repeatedly noted the sizeable increase in Asset Backed Commercial Paper outstanding in 2005-2007 as an example of such behavior. We would note that in today’s environment, volatility selling is an incredibly popular strategy.
The researchers note that the volatility risk premium is well below its historical average and has been in this depressed state since 2012. It does not take a Central Banker to figure out that 2013 was the year that ushered the FOMC’s massive but unnecessary QE3 program (chart below). That was soon followed by a massive expansion of the BOJ asset purchases and the ECB commenced its QE program the following year. The crux of the NY Fed’s conclusion is that:
“While the low volatility risk premium provides some evidence of complacency, we find the concerns based on the VIX mean reversion argument to be limited…while the current level of the VIX is low, it is difficult to pinpoint the horizon over which the VIX may increase. An open question is whether investors understand that volatility may be higher in the future. We explore this issue in our next post.”
This is the typical example of the Fed doing research and finding a result it does not like – that the low volatility environment represents complacency, then seeking an “on the other hand” explanation.
It will be interesting to see their next post – in which they will explore the open question of whether investors understand that volatility “may be higher” in the future. Our preferred way of illustrating the lack of volatility in 2017 has been by measuring the number of 1% daily changes (up or down). We are 87% of the way through the year and only 7 trading days, or 3% of trading days, have registered 1% moves, which compares to the long term average of 24% (chart below).
The reading is similar for 0.5% moves which have occurred 19% as compared to the long term average of 49% (chart below).
For those curious about where 2017’s strong gains come from, the up 0.5% days outnumber the down 0.5% day at a rate of 2.5 to 1 (chart below).
All of those small, low volatility gains have added up over the course of the year. Regardless, when one examines those charts that go back nearly 90 years, and sees that the current readings are testing extreme lows, investors better realize volatility will very likely rise in the future. One would need to seriously embrace the new paradigm thinking that “this time it is different” (which has ruined investors throughout history) to believe this is the new normal for volatility.
This is a Hedgeye Guest Contributor research note written by Mike O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.