Fear index flashing red. Worried about a low VIX? The calm before a share storm? Are investors too complacent? These are not my questions – they’re headlines published over the last week. Many commentators have taken the fact that globally share market volatilities are at historic lows, and twisted it at the extreme, to a warning of looming financial apocalypse.
The (investing) future is by its nature uncertain. More than thirty years trading markets teaches that nothing can ever be ruled out entirely. However, the idea that low volatilities mean shares are facing a meltdown is a good example of a little knowledge being a dangerous thing.
Global growth is recovering and despite strong rises, shares are generally not overvalued. Leverage remains low. Simply put, the key factors that contribute to market routs are not present.
So, how did so many “market experts” leap to a wrong conclusion? It’s pretty simple really. Take two similar but unrelated concepts, mix, and voila! Instant disaster.
Ingredient 1: The US VIX (the volatility index for the S&P 500 index) is sometimes referred to as the “fear index”. Under normal conditions, a high VIX means high levels of investor fear. A low reading is characterised as “complacency”.
Ingredient 2: The Benjamin Graham adage (often attributed to Warren Buffet) to be greedy when others are fearful, and fearful when others are greedy.
Blur complacency through optimism to greed, bake under deadline pressure, and we have the makings of a solemn warning to investors. But the very fact that there are so many people focused on a potential market crash makes it unlikely. Sir John Templeton stated many years ago the phases of a bull market, pointing out that they “die in euphoria” – definitely not the current market mentality. Instead, share markets are “climbing the wall of worry”, a previously observed and often sustainable phenomenon.
This long term chart of the S&P 500 index (green) against the VIX (red) shows that volatilities can reach low levels, and hover there, years before a major market fall. The period 2004-2007 is a case in point – the VIX touched 10% in 2005 and 2006, yet the market high occurred in November 2007. Note also the way volatility spiked well before the market fall in 2007/08 accelerated.
There are two actionable points for investors and traders. First, volatility is a key input to option prices. If investors are concerned about a possible crash, buying options as a portfolio or individual stock hedge makes more sense when volatilities are low. Secondly, the chart suggests a better use of the VIX as a signal is to buy shares on a volatility spike – judging from the number of rallies from spike points.