Leave it to a period of calm to inject nervousness into the market, as it did this week when the Chicago Board Options Exchange’s Volatility Index, or VIX as it is known, dropped to a level not seen in about 23 years. The drift lower in the so-called fear index has market watchers worriedly speculating about a calm before a storm.
Volatility
After all, financial markets are full of patterns, and the VIX’s downward swing had some market participants recalling its dip in 2007, shortly before the subprime mortgage crisis.
But Steve Heston, professor of finance at the University of Maryland’s Robert H. Smith School of Business, says he sees little to fear in the so-called fear index.
“It might be that VIX is fairly priced for the first time – and that risk is fairly low,” says Heston, who developed one of Wall Street’s most widely used Stochastic Volatility models. His statistical method in mathematical finance is used to evaluate derivative assets, such as options.
The VIX gauges expectations for future stock market gyrations based on prices in the options market. It represents the price the market is willing to pay to capture any profit from market movement over the next month, or three months. When the VIX is low, investors are betting that stock prices aren’t going to gain much, or lose much, over a prescribed time.
Historically, VIX options have been overpriced, Heston says, and selling the VIX has been profitable. With the surging popularity of exchange-traded funds (ETFs), there have been more sellers and fewer buyers for the VIX, driving its prices lower.
“So either options have gotten cheap because they should be cheap, because the market is not moving much lately, and it’s not expected to move, or it’s gotten cheap because people are not willing to pay as much for options, because they realize they’ve been historically overpriced,” Heston says.
The VIX has drifted lower since late last year, and Heston estimates that markets don’t see much market risk now that the elections are over. There hasn’t been a recent major terrorist attack, he says, and “despite his tough talk,” Trump has been “cautiously isolationist” in foreign policy. Trump’s one big trade negotiation so far has been on Canadian softwood lumber, a relatively minor matter that’s unlikely to roil the economy.
“It looks like we will have political gridlock, along with some back-and-forth on health insurance policy,” Heston says. But with the U.S. economy generally on firmer footing, that’s not likely to rattle investors.
Volatility is inversely correlated with stock prices, so when stocks are trading around historic highs, as they are now, it makes sense for volatility to be near historic lows, Heston says.
“But volatility is mean-reverting,” says Heston, suggesting that it will gravitate back toward its historical mean or average. “The lows are probably temporary. I can almost guarantee that the VIX will rise when the market falls. And I can guarantee the market will eventually fall.”
If there’s one thing investors know, it’s that nothing travels in a straight line. The stock market cannot keep hitting new highs forever.
“There will be more terrorism. There will be economic issues. The Fed will raise interest rates – or if they don’t raise interest rates, it will be for some reason,” Heston says. “Things will happen.”
Article by Smith Brain Trust
