Many articles have recently focused on the very low levels of the VIX index, the so-called “fear gauge” of the U.S. stock market. The VIX is designed to track the implied volatility of options on the S&P 500 Index: the higher the reading, the greater the market uncertainty. As shown in the chart below, the VIX is really just a reflection of the recently observed volatility in the market. Investors assume the volatility of the stock market tomorrow will look similar to the volatility of the stock market today.
So is the recent low stock market volatility an aberration as many believe? Taking a longer-term view, we tracked the realized volatility of the S&P 500 since 1928. Realized annual stock market volatility over the last year has been approximately 9%, which is well below the average of 16% over the previous 89 years. However, since 1928, the market has experienced volatility below 10% about one-fifth of the time — including for extended periods of time from the 1950s through early 1970s and again in the mid-1990s. In fact, the past 20 years look quite turbulent compared to other eras, with the exception of the Great Depression.
In certain instances low volatility can pose a longer-term problem, especially if it leads to lax risk management and excesses in the financial markets. The quiet period from 2004 through mid-2007 led to a massive U.S. housing bubble and over-levered banks, as both individuals and corporations quickly took on more debt. The debt bubble eventually burst, ushering in a new high-volatility regime for equity markets that endured for about five years.
There are many potential catalysts for higher market volatility going forward, considering the many unknowns in the world. Popular culprits include central bank tightening, geopolitical upheaval, a Chinese debt crisis and declining asset valuations. But it’s also possible we are just in a lower-volatility regime characterized by slow, plodding growth, low inflation and longer, more drawn out business cycles.
Equities tend to perform quite well during periods of low volatility. To illustrate this point, we looked at equity and bond returns on days where the VIX opened at low levels (15 or less), medium levels (15 to 25) and high levels (25 or more) going back to 1990. As shown below, equities performed best when volatility was highest – albeit with significantly greater volatility (as defined by standard deviation) in returns. But also noticeable is the clear outperformance of equities versus bonds during low-volatility periods as compared to medium volatility periods.
We are constantly searching for risks that have formed during this low-volatility period and that could lead to the next equity market selloff. We see some cracks in certain places, but not the excesses of the mid-2000s. In the meantime, we believe the low-volatility period could stretch out, providing a nice backdrop for our moderately pro-risk portfolio positioning.