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Summary

  • Large cap U.S. equity volatility is low in the current environment even when compared to the tame standards of 2013. The benign conditions raise concerns that stormier days lie ahead.
  • Historical patterns do show a tendency for volatility to surge after a long period of calm. But the calm can last for an extended period.
  • Moreover, what follows is not always bad. It is instructive to compare the aftermath of the previous two “low vol valleys” in the early 1990s and mid-2000s.
  • Current vol levels are neither unusually low nor glaringly overdue for mean reversion. In our opinion, fears of a looming 2007-like “Minsky moment” do not make a compelling base case.

Peaks and Valleys

Risk in asset markets is asymmetrical. Long periods of subdued volatility are followed by sudden, intense spikes of activity. Consider the following chart, showing the daily price trend of the CBOE VIX index from 1990 to the present. The chart presents an Andean landscape of sharp, steep peaks and comparatively gentle, rolling valleys:

(click to enlarge)

Source: MVF Research, FactSet

Data as of market closing prices, 2 June 2014

The CBOE VIX index reflects a weighted average of S&P 500 puts and calls over a range of strike prices

In this chart, we identify two earlier, extended periods of low volatility and a third, current low vol period still in formation. We define these "low vol valleys" as an environment where the VIX mostly stays below its historical average closing price of about 20. The calm lasted more than five years in the early-mid 1990s, interrupted only briefly by the Fed's 1994 rate hike surprise. After the 2000-02 secular bear market, equities settled into another benign low vol period for three years before the first ripples of the subprime loan crisis disturbed the surface. As for the present environment, it took Mario Draghi's famous "anything it takes" pronouncement in the summer of 2012 to allay fears of a Eurozone implosion and help coax the VIX back below the 20 threshold. The index is currently right around the low points of the previous valleys.

The current low risk situation, then, is not an outlier either in terms of where the VIX is relative to its long-term average, or in terms of its duration. That's not to say that conditions will stay this way indefinitely. Any number of lurking X-factors could emerge to produce another vertigo-inducing spike at any time. But we should not be unduly surprised if we do find ourselves in a protracted period of relatively low risk before the next surge.

After the Calm… What?

And when the volatility does return, what then? The earlier low vol valleys are instructive in this regard as well. By May 1996, the S&P 500 had gone more than 500 days without a peak-to-trough pullback of 5% or more. For no compellingly obvious reason the index did pull back by 7.6% from its peak close on May 22 to a floor close on July 24. Stocks resumed their merry way upwards with little fuss (see chart below), but volatility started to turn up as well. By early 1997, the VIX had re-established its baseline level above the historical average, and significant pullbacks were beginning to occur with more frequency.

(click to enlarge)

Source: MVF Research, FactSet

Daily price closings for S&P 500 and CBOE VIX; simple 50, 100 and 200-day moving averages for S&P 500

Of course, the luxury of hindsight tells us that getting out of the U.S. equity market in early 1997, with the reappearance of heightened volatility, would have been a spectacularly bad idea. Standard deviation cuts both ways, after all. In this case, a combination of higher risk and firmness at key support levels (e.g. at the 50, 100 and 200-day moving averages) underscores a bullish formation. As the bull runs its course, new money comes in chasing returns. X-factors become excuses to take money off the table - in 1997, the Asian currency crisis afforded such an opportunity - while support levels serve as a buying opportunity for frustrated value hunters.

By contrast, there was little in the way of a prolonged Indian summer for the secular bull that reached its peak in October 2007. The VIX languished in the neighborhood of 10 until rumors of an impending collapse of two Bear Stearns hedge funds with heavy subprime loan exposures led to a volatility spike in spring 2007 (see chart below).

(click to enlarge)

Source: MVF Research, FactSet

Daily price closings for S&P 500 and CBOE VIX; simple 50, 100 and 200-day moving averages for S&P 500

Baseline risk trended upwards and established firmness above the long-term average even as the S&P 500 attained its then-record close of 1565 on October 9. Before the end of the year, the equity index was failing to maintain support levels (unlike 1996-97), and we saw an inversion between the 50-day and 200-day moving averages.

Lessons For The Present

No two secular trends are identical. Sometimes volatility appears suddenly and brutally; other times it builds up slowly and provides a bullish tailwind even as baseline risk rises above long-term averages. We are neither in 1996 nor in 2007. That said, we do believe that evaluating volatility in the context of asset price formation trends - in particular firmness around key support levels - helps to inform our base case assumptions for near to intermediate-term positioning. With that in mind, we see the present environment offering more reasons than not to maintain a bullish base case orientation (see chart below).

(click to enlarge)

Source: MVF Research, FactSet

Daily price closings for S&P 500 and CBOE VIX; simple 50, 100 and 200-day moving averages for S&P 500

Latest date shown = June 2, 2014 close

What about the X-factors that could turn this relatively placid picture into something more frightful? They exist, to be sure. The Eurozone could fall back into a deep freeze, China's tightrope walk between GDP rebalancing and growth, the 2H landscape for corporate earnings are all in the mix. But history informs that it is a fool's errand to predict which X-factors will cause but a minor flesh wound, and which will inflict serious damage. Better to let the data speak, and for the time being the data suggest maintaining full or near-full U.S. large cap exposures.

Market indexes, including the S&P 500 and CBOE VIX shown here, are not investable. Price performance does not include fees and other expenses normally applicable to investable index proxies like mutual funds or exchange traded funds.

Business relationship disclosure: MV Financial is a team of registered investment advisors and asset managers. This article was written by Katrina Lamb, CFA, one of our asset strategy managers.

Please click here for important additional disclosures about MV Financial.

Source: Return To The Valley Of Low Vol