After years of relative calm, financial markets are moving into a new, more intense volatility regime.
After years of relative calm, financial markets are moving into a new, more intense volatility regime.
"If you throw a dart at any measure of equity volatility, you'll find evidence of a change," said Jared Woodard, senior equity derivatives strategist at BGC Partners, who highlighted increases in realized volatility, implied volatility, and the cost of downside put options relative to out-of-the-money call options as signs of increased risk aversion amongst market participants.
The CBOE Volatility Index, or VIX, often called the "fear index," measures the expected volatility in the S&P 500 over the next 30 days implied by the price of options for the benchmark U.S. equity index. Typically, the VIX index and the S&P 500 move in opposite directions: As investors expect larger near-term fluctuations in stock prices, the S&P 500 tends to decline.
The most recent Commitment of Traders report from the U.S. Commodity Futures Trading Commission showed that the non-commercial net long position – a proxy for hedge fund holdings – in VIX futures has reached its highest level on record, going back to 2004.
The current positioning in VIX futures has come about via a steeper decline in net short contracts than net long contracts since December, an indication that hedge funds' desire to bet against volatility has waned.
The easiest, and likely, best, explanation for the return of volatility is tied to recent and expected changes in U.S. monetary policy.
"The end of quantitative easing and anticipation of the commencement of a tightening regime is really what's driven the higher base level in equity volatility through the channel of currency and commodity volatility," said Jarret Christie, volatility strategist and sales trader at Macro Risk Advisors.
A paper written by Ji Tan and Vaibhav Kohli of the University of California, Berkeley found that quantitative easing had a "significant negative impact" on stock market volatility. The abundant liquidity provided through these asset purchases, no doubt, helped push investors into riskier investment opportunities and quelled their fears by providing a sense of security that the central bank would be there to serve as a backstop for equities.
The use of forward guidance – where central banks inform the market of the future path of policy rates – is another form of unconventional monetary policy that also helps remove uncertainty and flatten the yield curve, providing additional incentive for investors to boost their exposure to equities.
"The volatility of a return to two-way trading is the future price of successful forward guidance today," wrote Bank of Canada Governor Stephen Poloz in a discussion paper published in October.
Mr. Woodard of BGC also notes that the divergence in real growth outlooks – with the United States gaining momentum while the rest of the world, by and large, loses steam – has helped usher in more volatility, and the potential for a peak in the U.S. profit cycle as wage growth picks up could amplify this development.
In this new volatility regime, investors should be aware that the old rules about volatility may no longer apply.
In recent years, a move in the VIX index above 20 has served as a useful signal to buy the S&P 500, as the "fear index" dropped off significantly shortly thereafter. With a heightened base level for volatility, however, readings above 20 have occurred more frequently in recent months, heightening the prospect that this signal could turn into noise.
Spikes in volatility will, in all likelihood, prove to be excellent times to put cash to work in the market, but it's certainly easier to recognize when that occurs with the benefit of hindsight.
Retail investors may find it increasingly difficult to stick with positions in an era of heightened volatility, as more substantial day-to-day market gyrations offer more opportunities to question one's investing thesis. However, those who adopt a buy-and-hold approach should strive to maintain discipline – expertise in market-timing is rare, and the fees that accompany excessive trading are likely to eat into any profits.
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