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Where has all the volatility gone?

A lot has been discussed in recent weeks about the period of low volatility we are currently experiencing in the markets.  I touched upon this briefly in one of my recent market commentaries but I felt like a deeper dive was needed into the phenomenon.

By almost any measure, volatility is at historic lows.  The VIX, which tracks the 30-day implied volatility of S&P 500 component stock options, and is widely accepted as the markets barometer for volatility has steadily marched lower since the financial crisis.  During the peak of the crisis in 2008, the VIX reached levels near 60 but in the last week, we have seen it hover at historically low levels near 10. So far this year we have also seen a number of record setting stretches including when the market went for almost 5 months without experiencing a 1% negative move on any day.

So the big questions that emerge are: what is causing this low volatility environment? Is this new low volatility the new norm or will we snap back to more “normal” levels? And most importantly, when will volatility return?

There are a number of factors that could explain why volatility is so low. Here are few of the more interesting ones:

  • Changes in information flow: This is an interesting one that I don’t normally hear discussed. However, I think it is an important one to consider. Over the last 20 years we have seen access to and the flow of information increase dramatically.  The internet, social media, the 24-hour news cycle and Twitter have put almost any information we could possibly need right at our finger tips. With so much access to information, there are fewer surprises. Everyone from the Warren Buffett to the trader at home knows everything that is going on in the world at all times. All of this data overload has reduced the number of shocks to the markets. Based on advanced modeling, leading indicators and the speed of information flow the market has the ability to react by the millisecond. If there are no surprises and all information is always available than one would assume that the markets would become more efficient and volatility has to come down as a response
  • ETF and Index trading: In a recent podcast Steve Bregman discusses this topic and I think it is an important one to consider because if he is right then it is setting the stage for a potential rapid increase in volatility if this trend reverses. In summary, the rise in popularity of ETF investing over the past few years, and the massive inflows away from active management and into passive are causing a wide range of stocks to be propped up artificially.  When a large ETF, like SPY, sees inflows, management has to go out and buy a majority of the stocks in the underlying index in order to mirror performance. This buying is not selective and has little to do with the fundamentals of the underlying companies. Since they are forced to buy, this dynamic is creating bids to buy all of these stocks, even the low-quality  These “artificial” bids prevent these stocks from selling off to the extent they really should if they were trading on their underlying fundamentals. This reduces overall volatility and mutes any potential market pullbacks. As long as flows continue into these passive vehicles there will always be someone out there buying the stocks.  The scary part about this is that if this trend reverses and flows stop going into these stocks then the pullback could be dramatic.  The artificially propped up stocks will not only give back these artificial gains but then pull back to where their fundamentals say they should be trading. Further, there will be forced selling of the quality stocks too, exacerbating the problem. The argument against this has been made that a lot of stocks have seen big pullbacks over the last few years so all ships are not being lifted with the ETFs.  My contention, however, would be, would these companies have pulled back even more if there weren’t ETFs being forced to buy them?
  • Post crisis tail risk fear: Following the financial crisis market confidence was at all-time lows and the fear of another tail risk event was on everyone’s mind. This fear caused many investors to pay crazy amounts for options to hedge any exposure they had. With investors willing to pay so much for protection, implied volatility stayed high. Even further, hedge funds who had missed out on making money on the financial crisis began to make more and more bets on tail risk events, hoping for another shock to the system. In the 9 years since the financial crisis, few of these tail risk bets have paid off so managers are now more reluctant to make them causing the VIX to drop. As the crisis moved further into the past, investor’s confidence also returned and their desire to buy option protection decreased. As options become less expensive, implied volatility also comes down dragging the VIX with it.  The interesting thing we have seen, however, is that numerous pundits are now screaming about an impending pullback but volatility still remains low.
  • Calm, stable period: The simplest answer to the low volatility question may be the most probable. Maybe we are just in a very calm, stable period for the financial markets.  The economy is currently at full employment, inflation is low and although GDP growth has been below its long term averages it has been very stable and predictable over the past few years. Additionally, even though we hear a lot of talk coming out of Washington, not a lot has happened to shock the system. Further, there are a lot of geopolitical tensions in the world but it has been years since we saw a major geopolitical threat come to fruition. A stable economy, minimal shocks to the system and no tail risk events coming to fruition may have just lulled the markets into this complacent state. This isn’t the sexiest explanation and even in this environment valuations may be getting stretched but until there is a major catalyst to shake things up the markets are comfortable with their slow steady march forward.

These are obviously only a few of the possible variables that may be driving this low volatility environment and it is most probable that a combination of factors has led us to where we are. As an investor, the questions still remains, what will change this current pattern?

Every day we read more and more about how a major pullback is coming. Whether this pullback is simply a natural market consolidation driven by overstretched valuations or a more severe geopolitically driven sell-off, it is important to not get lulled to sleep by current conditions.  As I’ve written about in the past market pullbacks are normal. The risk lies in whether there have been changes in market dynamics that could lead to a more severe pullback than normal.  If multiple factors are contributing to this low volatility environment and a few of them reverse or break down than the pullback could be exaggerated.

I, for one, think the fundamentals in the market are strong and without any major geopolitical disruption or major policy shift in Washington expect the market to continue to march higher.  We may see some profit taking here and there and some short term pullbacks but the foundation is set for the bull market to keep marching.

My fear, however, still lies in a tail risk event that causes panic selling. While we are years removed from the financial crisis, most investors still remember it vividly and they don’t want to be there if it happens again.  And while ETF flows may have propped up stocks on the way up, they could have the reverse impact on the way down, as forced selling drags down the quality stocks too. As low as the probability of such an event may be, all of this paints a dire picture if a real shock hits the markets.

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