The CBOE VIX index touched unusual low levels Monday and Tuesday, only similarly closing under the 10 level 10 previous times in its history, a Source report noted. The historic low volatility has caused “unease” among a majority of investors, according to a recent Bernstein report. But Source Head of Research Paul Jackson and Director Andras Vig say don’t worry, it’s not that big a deal.
Low volatility amid a global expansion period is normal
The current low volatility regime “is not that unusual,” Jackson and Vig write in a May 18 report titled “Shhhhh…”
Working on the basis of “where we are in the economic cycle,” they operate under the thesis that when a market grinds higher, low volatility should be expected.
To build their model, they looked at the twenty largest markets — Australia, Brazil, China, Canada, France, Germany, Hong Kong, India, Italy, Japan, the Netherlands, Russia, Singapore, South Korea, Spain, Sweden, Switzerland, Taiwan, the United Kingdom and the United States – and mapped economic growth and historic volatility.
“The economies of all the markets we have analysed are in the expansion phase now, thus the economic cycle should support equity markets,” they wrote.
Looking at the level of volatility and dividing it into categories, they note that the low volatility range the S&P 500 witnessed Monday and Tuesday was rare, with only 8% of trading days worldwide falling into this category. But low volatility is generally the rule, not the exception, the study of 20 different markets notes.
To bolster their analysis, the considered the standard deviation of stock market returns over the previous three levels of standard deviation of trading days – 66 days – a common method to measure volatility that they too back to 1973. Source notes that it is not low volatility that is rare, but high volatility.
Global stock markets spend fully 50% of the time in the lowest 15 percentile volatility levels, which is the equivalent of the VIX trading under 20. “The current level of volatility is within the lowest 15 percentiles in all the 20 markets we analysed,” they wrote.
“Equity bull markets are generally associated with low volatility as share prices tend to grind higher, so low levels of volatility should not be that surprising,” the report stated, pointing to the failure of populism as one catalyst of low volatility. “We also think that political risk has now been reduced for the rest of the year as populists have not been as successful in this year’s elections as feared.
There are volatility risks, but they are mostly associated with the “unknown unknowns”
This isn’t to say risk doesn’t exist and the market threat of populism could again reappear. The report ticked off four primary global risks among many others:
- Slowdown in the US economy
- Debt crisis in China
- Intensifying tensions on the Korean Peninsula and in the Middle East
- Parliamentary elections in Italy with a strong showing by the Five Star Movement
But what really is of concern is the risk that is not anticipated. Here Jackson and Vig rely on a volatility trader’s traditional mantra: true volatility is created by what is not anticipated. What the report titled the “unknown unknowns,” a borrowing on former US Defense Secretary Donald Rumsfeld’s famous quote.
It is the surprising risk, such as a highly successful cyberattack that wipes out critical infrastructure or a terrorist attack taken to the next level, that is likely to wake up worldwide volatility that has fallen asleep.