Raul Elizalde - March 19, 2012
Judging by the low trading volume or the outflows from equity mutual funds,
investors by and large sat out a huge stock rally that pushed the S&P500 up
close to 30% since last October. We recently commented on this lack of
conviction ("Rally
or Not?" - 3/6/2012.
One thing, however, is clear. Fear is no longer a dominant emotion. While market participants felt they were hanging on for dear life for most of the second half of 2011, they now seem considerably more relaxed. At least this is what the “fear index”, or VIX, suggests today. Last week the VIX ended below 15% - after dropping briefly below 14% - for the first time since mid-2007, before the financial crisis. But while lower volatility is a good thing, it may also be an augur of an upcoming market correction.
The VIX is the implied volatility of S&P 500 options, and indirectly measures the price that investors are willing to pay to insure against a drop in the index. When investors are fearful they seek insurance for their stock holdings and therefore the VIX goes up; when investors are confident they care less about insurance, and the VIX goes down.
As we noted, investors are not fully translating this newly-found confidence into aggressive participation in the stock market. This reticence may turn out to be a good thing: judging by the low VIX, investor lack of fear risks turning confidence into complacency. This is an important distinction. Confidence can be healthy, but complacency almost never is.
On one hand, there are many reasons for investors to feel confident that the market is on a solid path. We find technical and fundamental reasons to be optimistic. Not only are historical patterns consistent with a strong 2012 (see “2011 Part II – Can 2012 be different?” - 1/5/2012), but also the US economy is steadily adding jobs while various indicators point to growth. Europe has agreed to a bailout of Greece, removing a big source of concern that weighed on markets in recent months. And even if Greece ultimately defaults, the continent seems to have built up defenses against a spillover crisis.
Concerns about a double-dip or an out-of-control crisis in Europe have kept markets below the highs of 2007, or, for that matter, below the peaks of 12 years ago. Removing those concerns could pave the way for the market to regain its former highs.
But some complacency may be building up in the steamrolling climb of the S&P, and the canary in the coal mine is the low value of the VIX itself. For almost five years, since mid-2007, every time the weekly VIX average declined below 16.1% the market tumbled an average of 6% in the subsequent 3-5 weeks, and as much as 17%. We pointed this out late July last year, and the market dutifully fell in August.
Noting that low levels of VIX are followed by a market reversal may lead investors to conclude that the market cannot truly be trusted. This is an unsettling consequence of one of the most difficult market periods in memory and it may be at the core of why investors remain unconvinced that placing large bets is a good idea. The outflows from equity funds and low trading volumes suggest this is what is taking place.
If they are right to be reticent, then the recent dips in actual and implied volatility will once again prove to be just a temporary lull before another storm hits. But they could also be wrong. After all, markets don’t remain in crisis mode forever. The decline in volatility may mark the beginning of calmer, more “normal” markets.
To define “normal” we looked at almost two decades before 2007, when the implied volatility’s weekly average would fall as low as 10% without it signalling a subsequent market fall.
It was not until 2007 when markets started behaving very differently, as volatility reached exceedingly high levels and stocks started to move in concert, falling and climbing as risk appetite was turned “on” or “off.” As a result, the correlation among all the stocks that make up the S&P 500 spiked to exceedingly high levels. This “herd mentality” amplified swings, making high volatility and high correlation feed off each other. And the prevalence of global risks meant that drops in volatility never really took hold.
While inter-stock correlation has declined a lot – from over 86% in late 2011 to about 72% now, it remains far higher than the 40% level in place of early 2007.
So although volatility has come down lately to very low levels, high inter-stock correlation suggests that the market structure has not yet returned to pre-crisis levels. If this is the case, the current low levels of VIX are a warning sign that the market could retrace early in the second quarter.
It’s not clear what could derail the bull market, even temporarily. But the most likely culprit would be earnings. Recent reports suggest that US corporate earnings will register their first quarterly decline since the third quarter of 2009. And the earnings season will begin right at the time when the recent drop in volatility suggests a stock market swoon.
This does not mean that the market will fall in a precipitous way like last August. It could merely be a small 5%-10% correction from which stocks could easily recover if headline risk factors remain subdued. This will require ongoing monitoring to prevent portfolios to suffer losses beyond what might be tolerable. But a modest market fall could give investors a healthy reminder that nothing goes up in a straight line. It would be a good way to keep them from becoming complacent.
One thing, however, is clear. Fear is no longer a dominant emotion. While market participants felt they were hanging on for dear life for most of the second half of 2011, they now seem considerably more relaxed. At least this is what the “fear index”, or VIX, suggests today. Last week the VIX ended below 15% - after dropping briefly below 14% - for the first time since mid-2007, before the financial crisis. But while lower volatility is a good thing, it may also be an augur of an upcoming market correction.
The VIX is the implied volatility of S&P 500 options, and indirectly measures the price that investors are willing to pay to insure against a drop in the index. When investors are fearful they seek insurance for their stock holdings and therefore the VIX goes up; when investors are confident they care less about insurance, and the VIX goes down.
As we noted, investors are not fully translating this newly-found confidence into aggressive participation in the stock market. This reticence may turn out to be a good thing: judging by the low VIX, investor lack of fear risks turning confidence into complacency. This is an important distinction. Confidence can be healthy, but complacency almost never is.
On one hand, there are many reasons for investors to feel confident that the market is on a solid path. We find technical and fundamental reasons to be optimistic. Not only are historical patterns consistent with a strong 2012 (see “2011 Part II – Can 2012 be different?” - 1/5/2012), but also the US economy is steadily adding jobs while various indicators point to growth. Europe has agreed to a bailout of Greece, removing a big source of concern that weighed on markets in recent months. And even if Greece ultimately defaults, the continent seems to have built up defenses against a spillover crisis.
Concerns about a double-dip or an out-of-control crisis in Europe have kept markets below the highs of 2007, or, for that matter, below the peaks of 12 years ago. Removing those concerns could pave the way for the market to regain its former highs.
But some complacency may be building up in the steamrolling climb of the S&P, and the canary in the coal mine is the low value of the VIX itself. For almost five years, since mid-2007, every time the weekly VIX average declined below 16.1% the market tumbled an average of 6% in the subsequent 3-5 weeks, and as much as 17%. We pointed this out late July last year, and the market dutifully fell in August.
Noting that low levels of VIX are followed by a market reversal may lead investors to conclude that the market cannot truly be trusted. This is an unsettling consequence of one of the most difficult market periods in memory and it may be at the core of why investors remain unconvinced that placing large bets is a good idea. The outflows from equity funds and low trading volumes suggest this is what is taking place.
If they are right to be reticent, then the recent dips in actual and implied volatility will once again prove to be just a temporary lull before another storm hits. But they could also be wrong. After all, markets don’t remain in crisis mode forever. The decline in volatility may mark the beginning of calmer, more “normal” markets.
To define “normal” we looked at almost two decades before 2007, when the implied volatility’s weekly average would fall as low as 10% without it signalling a subsequent market fall.
It was not until 2007 when markets started behaving very differently, as volatility reached exceedingly high levels and stocks started to move in concert, falling and climbing as risk appetite was turned “on” or “off.” As a result, the correlation among all the stocks that make up the S&P 500 spiked to exceedingly high levels. This “herd mentality” amplified swings, making high volatility and high correlation feed off each other. And the prevalence of global risks meant that drops in volatility never really took hold.
While inter-stock correlation has declined a lot – from over 86% in late 2011 to about 72% now, it remains far higher than the 40% level in place of early 2007.
So although volatility has come down lately to very low levels, high inter-stock correlation suggests that the market structure has not yet returned to pre-crisis levels. If this is the case, the current low levels of VIX are a warning sign that the market could retrace early in the second quarter.
It’s not clear what could derail the bull market, even temporarily. But the most likely culprit would be earnings. Recent reports suggest that US corporate earnings will register their first quarterly decline since the third quarter of 2009. And the earnings season will begin right at the time when the recent drop in volatility suggests a stock market swoon.
This does not mean that the market will fall in a precipitous way like last August. It could merely be a small 5%-10% correction from which stocks could easily recover if headline risk factors remain subdued. This will require ongoing monitoring to prevent portfolios to suffer losses beyond what might be tolerable. But a modest market fall could give investors a healthy reminder that nothing goes up in a straight line. It would be a good way to keep them from becoming complacent.
Raul Elizalde | raul@pathfinancial.net
©2011 Path Financial LLC
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