Market Insights: Does low volatility mean that the market is due for a fall? | BetaShares

Market Insights: Does low volatility mean that the market is due for a fall?

BY Louis Crous | 20 August 2014
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Possibly one of the most commented on areas in the market over the recent period has been the low trading volumes and the low level of volatility across asset classes. The S&P 500 Index, for example, had 55 consecutive days with market movements of less than 1% in the last quarter to June 2014. The Chicago Board Options Exchange’s VIX Index, a measure of the implied volatility of the S&P 500 Index and generally known as the “fear index”, recently hit a low of 10.32. These low levels have not been seen since 2007 and, prior to this, since 1993/4. Some investors and market commentators have highlighted these trends as a sign that we are poised for a significant correction due to a belief that the low volatility is as a result of investor complacency, and the VIX will return to average levels.

Volatility

Source: BetaShares, Bloomberg

Will there eventually be an increase in volatility that coincides with a market pullback? Of course. However, I would like to point out that low volatility environments can last for quite some time. The chart above highlights these periods along with the performance of the S&P 500 during these periods. As you can see from the chart, investors being fearful too early during these  low volatility periods, and selling market exposure, would have missed out on meaningful returns from the Index.

Market volatility levels are very much tied to business cycles. Realised volatility has tended to rise sharply during recessions before gradually declining as the economy recovers. As mentioned, these periods can last for quite some time, but even more interesting is the fact that, historically, stock markets have tended to move higher initially even as realised volatility moved higher towards the next recession. The low volatility environment we are experiencing is much in the range we can expect to see given where we are in the business cycle.

As for risk of complacency, I see little evidence of this in the market. Cash levels amongst households and corporate are still high following a period of deleveraging, economies are rebuilding and inflation is low. In addition, for those of you that have an interest in the options market, you may have noticed that across asset classes the risk premiums (the implied volatility versus actual volatility which is ‘priced into’ the options market) are at historic highs and implied volatility terms structures are very steep (indicating an expected increase in future volatility). Hardly the stuff of complacency.

There is no doubt that the equity markets have had a great run. However investors worried about a pullback may want to consider the historical relationship between low volatility and eventual market declines when determining the extent to which they would like to reduce their exposure to the market.

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