Is Volatility's Vacation Nearing an End?

Natixis Asset Management
 

“Markets are by definition uncertain. However, everywhere we look we see that level of uncertainty increasing,” said Bourdeix. As a result, he believes volatility could spike up anytime now.

Bourdeix believes we are currently at a crux for asset allocators. In the U.S., if inflation picks up over the coming months, the Fed will be torn between keeping its accommodative stance and hence allowing equity markets to transition into bubbly waters or starting to hike rates. “We must not underestimate the lack of liquidity in certain segments of the fixed-income market, and even a minor interest rate hike by the Fed could be the trigger for a significant technical market movement,” said Bourdeix.

U.S. equities starting to look pricey
U.S. equities are beginning to look expensive to Bourdeix when he analyzes the CAPE Shiller index (Cyclically Adjusted Price to Earnings Ratio developed by Robert Shiller). “Should equity prices continue to rise at a faster pace than corporate earnings, they will start approaching the bubble zone, similar to the late 1990s configuration where volatility increased during the ‘euphoria’ phase of the bull market,” said Bourdeix. A similar situation occurred also at the very end of the 2003–2007 bull market.

Since 2009, investors have experienced a zero-rate environment, the lowest and longest on record, according to Bourdeix. Hence, the uncertainty regarding potential interest rate hikes is much higher compared to the last two rounds of rate hikes that took place in 1994 and 2004.

Bourdeix and his group have closely examined where the “real” interest rates have been lately versus where they should theoretically be according to SeeyondSM priority economic models. “The cut to zero was justified as theoretical rates were heading towards zero, and quantitative easing was warranted by the fact that theoretical rates were evolving below zero. Since then, theoretical rates have recovered and the trend is pretty clear: From now on, neither quantitative easing nor zero rates are justified, and the longer we stay in the current zero rate environment, the bigger the risk for the Fed to loosen its grip on monetary policy,” said Bourdeix. This is why he believes hawkish members of the Federal Market Operating Committee (FMOC) are currently pressuring Fed Chair Janet Yellen to speed up subsequent interest rate hikes.

Growing risks in Europe and Japan
On the contrary, in Europe, if growth remains disappointing, the economy may not be sufficiently resilient to absorb an increase in energy costs fueled by geopolitical tensions in the Middle East. Europe would therefore face a potential risk of deflation. In this anticipation, markets are likely to fall and volatility to rise. Besides, Japan is finding it more difficult than anticipated to overcome its recent value-added tax (VAT) rate hike and is clearly not out of the woods yet.

Performance of volatility investments has been lackluster for the past year or so, and some investors are questioning the utility function of a volatility investment within a global allocation. Bourdeix believes it is probably a good time to consider adding exposure to this asset class and be prepared to meet head-on the wall of challenges and uncertainty the global economy will have to climb in the coming months – especially as shifts in monetary policy from central banks play out.

Gateway Investment Advisers
 

According to Merriken, the low level of stock market volatility, as measured by the VIX, in 2014 has led investors to question whether volatility is permanently depressed due to market complacency or whether the VIX itself has become overtraded. Neither of these scenarios appears accurate to Merriken.

Fed QE behind depressed volatility
In fact, Merriken points out several reasons why the VIX is so low today, all of which reflect an interesting mix of market forces acting in concert. And behind all of it is the Fed’s quantitative easing (QE) program. “First, overall equity market volatility as measured by the VIX has moved in a narrow range. So although the range has drifted higher over time, the volatility index value has been well-contained. Second, call option prices rise along with volatility and interest rates. Therefore, in a period of depressed short-term interest rates, option prices – and implied volatility – are also depressed. That’s because, although options pricing takes into account many variables, an option’s value is heavily influenced by interest rates and volatility,” said Merriken.

Referring to the calculation of the VIX, Merriken explains that included in an option’s premium (the current price of any specific option contract) is a consensus estimate of volatility, often referred to as implied volatility. “Volatility must be implied because, unlike interest rates, the expected volatility over the life of an option cannot be observed. The VIX is computed on implied volatility over a range of shorter-term, near-the-money contracts,” said Merriken. As such, volatility estimates come from observing the trailing level of market volatility, or realized volatility.

Another key reason for low volatility today, Merriken believes, is that Fed liquidity tends to depress both interest rates and market volatility. “In the current market, liquidity abounds. As investors observe falling prices, they deploy excess cash into the market. Investors’ eagerness to deploy excess capital is one reason the market has failed to achieve a 10% correction over the last three years, despite several market declines,” said Merriken. However, as the market rallies off what many consider a false bottom, the lack of overall conviction in buying encourages early profit-taking. “As a result, prices peak well short of excessively extended levels. This tends to reduce the trading range of the market. The net effect is to depress the VIX,” said Merriken.

Lastly, while an increase in products and trading based on the VIX has allowed investors to take a view on market volatility, no evidence links the larger trading volume in VIX-related contracts with lower volatility. Therefore, he does not believe the VIX is overtraded and causing low volatility. But there is direct evidence that links equity trading volume with realized volatility, a root variable in determining the VIX, according to Merriken. This evidence, he believes, suggests Fed quantitative easing action is behind reduced market volatility and option premiums.

Stimulus exit expected to boost volatility
“Going forward, as the Fed removes monetary accommodation and interest rates ultimately increase, I expect that two separate, although not independent, factors will likely cause option prices and implied volatility (VIX) to increase – market volatility and rising interest rates,” says Merriken.

AlphaSimplex Group
 

Market volatility, as measured by the VIX, was certainly low for the first half of 2014. However, Healy believes investors should be taking broader measures of volatility than that.

For example, the volatility of volatility, or how quickly volatility can change over time, appears to have increased over the last decade. As a result, Healy believes investors should probably be more dynamic in how they construct their portfolios to account for rapidly changing market environments.

Healy adds that while the VIX is the most widely quoted measure of market volatility, it is important to keep in mind what the VIX actually is. “It is an estimate of the ‘implied volatility’ of the S&P 500® over the next 30 days, based upon the prices of S&P 500 options contracts,” said Healy. As such, it is a short-term, U.S.-centric measure and its level is driven by activity in options markets.

Simply stated, a low VIX reading means that the demand for options, or short-term insurance on the S&P 500, is currently low by historical standards. This makes perfect sense to Healy given that the companies in the S&P 500 have delivered consistent earnings and there is a very accommodative Federal Reserve in the U.S. that has made it clear that it does not expect to change its stance in the near future.

Above-average risk levels in emerging markets
Healy notes that a low VIX is also consistent with AlphaSimplex Group’s (ASG) own measure of risk, the Downside Risk Index (DRI),* which has averaged around 28 during the first half of 2014, well below its long-term average level of 55. However, ASG’s measure takes a broader scope and encompasses global markets. “By our measures, emerging markets have above-average risk, with Russia, Hungary and Chile (among other South American markets) exhibiting Downside Risk Index readings in the 60s and 70s, well above the U.S. reading of 28. So, while global uncertainty may not be reflected in the VIX, it appears to be reflected in some international markets,” said Healy.

In light of this, investors may be asking if U.S. volatility will increase anytime soon. While ASG does not attempt to predict volatility shifts or macro events, Healy points out that they have done extensive research analyzing market behavior. One such market behavior that is well documented is mean reversion – i.e., the tendency for asset prices to return to their historical averages over time. “We do expect measures of volatility, such as the VIX, to mean-revert over time. Specifically, given how low the VIX is currently relative to its historical average, we would expect an increase in volatility in the future. For us, it is not a question of if volatility will increase, it is a question of when,” said Healy.

Low-stress environment driving investor diversification
ASG’s research into market behavior also suggests that investors make poor decisions in times of stress because they are influenced by their emotions rather than rational planning. But what Healy is seeing today does not appear to be one of those environments. In fact, it appears to be just the opposite: a low-stress environment. “This is why I believe some investors are taking this opportunity to evaluate their portfolios and consider adding strategies with low correlation to stocks and bonds, such as trend-following strategies like managed futures,” said Healy.

Healy believes that if investors wait to diversify portfolios until there is a crisis, it may be too late. “Firstly, they will most likely miss out on the diversification benefits of a thoughtful allocation. Secondly, they run the risk that in a crisis their emotions will impair their ability to make the most rational decision, potentially making a bad situation even worse,” said Healy.

Overall, Healy believes markets are adaptive and volatility is not constant. For example, the VIX averaged less than 14 for the first half of 2014 and recently even dipped below 11. Contrasting this level with the financial crisis of 2008–2009, when the VIX hit 80, is just one of many examples of how volatility and market dynamics can vary over time.
 

*The Downside Risk Index is a proprietary index designed by AlphaSimplex to reflect the recent downside volatility of U.S. equity markets. Downside volatility is a measure of the extent to which recent volatility in the daily returns of a major index representing equity returns of a specific country or region has resulted from negative price moves (as opposed to volatility resulting from positive price moves). The DRI can range from 0 to 100, and higher values indicate that the recent level of downside volatility has been high relative to historically observed levels of downside volatility. The DRI is not a prediction of future returns or volatilities of U.S. equity markets, and investors should not rely on this index when making investment decisions.