How to get your kicks from the VIX

Money folded into boats

Neither a natural disaster in Texas, nor elevated tensions between Washington and Pyongyang, the tardy pace of Brexit negotiations or soggy wage growth worldwide have stirred stock markets from their slumbers over the summer.

Across June, July and August, the FTSE 100 rose or fell by 1% or more in a single day’s trading just seven times – once every 9.4 trading days.

America’s S&P 500 moved by such a degree just twice – once every 32.5 trading days.

To put that in context, since 1995, that compares to a 1%-plus daily gain or decline every 3.6 days in the both the UK and US.

By historic standards, markets are indeed quiet – in the whole of 2017, the FTSE 100 has moved by this much a mere 11 times and the S&P 500 has done so on just six occasions.

This begs four questions:

  • Why are stock markets so quiet and so calm, despite ongoing geopolitical tensions, political uncertainty in the US and the EU and mixed messages from central banks?
  • Are they right to be so calm?
  • What could change their minds – and how can advisers and clients measure this?
  • And what should advisers and clients think of doing, if volatility returns to more normal levels (or even spikes to thresholds seen during the – relatively mild – wobbles of 2011, 2015 and 2016, let alone the highs seen during the panics of 2001-2003 or 2007-2009).

Summertime snooze

From a stock market perspective, key indices were relatively becalmed in the summer, even as the US trio of the Dow Jones Industrials, the S&P 500 and the NASDAQ Composite managed to set new all-time highs.

In fact, they have been quiet all year. The S&P 500 is on course to provide the fewest daily moves of more than 1% since (at least) 1995 and the FTSE 100 since 2005:

America’s S&P 500 is at its quietest since 1995

Source: Thomson Reuters Datastream

The FTSE 100 is at its quietest since 2005

Source: Thomson Reuters Datastream

Advisers and clients could well view this as a good thing. Both indices are at or near their all-time highs. And the periods 1995-2000 and 2005-2007 saw further gains in US and UK stocks.

Such calm seems odd, when Washington and Pyongyang are involved in a nuclear stand-off, the Brexit talks in Brussels are barely moving and central banks are still running monetary policies which are extremely accommodative as if to suggest they have their doubts as to how sound the economic foundations really are. The Bank of England, European Central Bank and Bank of Japan are still holding interest rates at record lows and running Quantitative Easing (QE) schemes at full tilt while the US Federal Reserve is tightening policy by raising rates incredibly slowly, some four years after it first hinted at such a move.

Intriguingly, the yield on 10-year UK and US Government bonds is retreating again, while gold is trading at an 11-month high (in dollar terms) at around $1,340.

Government bond yields are falling again

Source: Thomson Reuters Datastream

Both trends are usually indicators of risk aversion, yet stock markets appear remarkably calm all the same.

Happy pills

It is possible to argue that equity investors are correct to ignore the shadow cast by renewed racial tension in America (and the politicking which this provoked), the fears aroused by the (verbal) jousting between President Trump and North Korea’s Kim Jong-un and the modest progress made by David Davis and Michel Barnier in the Brexit talks.

Important as all of these issues are in their own right, none of them (directly or immediately) affect the profits and cash flows that ultimately drive company valuations and dividend payments, and thus the total return from equities.

Equally, markets may be taking the view that neither Trump nor Kim wants a nuclear conflict and that some form of common sense will ultimately prevail.

Equities also appear to be taking the view that central banks still have their back as cheap liquidity leaves oceans of cash sloshing around looking for a decent (risk-adjusted) return – and many advisers and clients may favour stocks, given the appalling interest rates available on cash and the historically low yields offered by (Western) government, corporate and high yield bonds.

Only an acceleration of the Fed’s tightening programme, or a shift on policy from the European Central Bank, Bank of England or Bank of Japan may change this perception – and that does not look too likely in the immediate future.

The fear index

This is not to say advisers and clients can complacently head back to the beach.

Those with long memories will remember the 1997-1998 Asian currency crisis and Russian debt default that wiped a fifth off UK and US stock valuations in barely a couple of months in late 1988.

That came just two years after the S&P 500 showed the sort of muted daily volatility we are seeing now.

Nor will advisers and clients forget the 2007-2009 Great Financial Crisis, and the thumping bear stock market that accompanied it, in a hurry.

That came just two years after the FTSE 100 showed the least daily volatility in the last 22 years.

As such, unusual periods of calm can quickly lead to periods of great uncertainty – not least as the calm encourages more risk taking (because making money looks easy) and ultimately to just the sort of risk taking that leads to problems and market accidents, as valuations are bid up to silly levels, debt is used to fund stock purchases and vital disciplines are lost.

Thankfully, advisers and clients do not have to do the legwork that AJ Bell has carried out by analysing daily stock index movements over the past two decades, to judge whether markets are becoming unduly calm – and perhaps overconfident – or not.

The shorthand version of doing this is to look at the so-called fear indices, the VIX for the USA and its UK equivalent, the VFTSE.  Both can be followed (for free) on the internet.

These benchmarks look at implied volatility over the next 30 days and thus provide a snapshot of how lively other participants think markets will become over the coming month.

At the time of writing, the VIX stands at 10.1, compared to post-1990 (lifetime) average of 19.4.

The VFTSE stands at 13.0, compared to a post-2000 (lifetime) average of 19.8.

No-one seems to expect that there will be any trouble ahead.

Yet as history shows, markets tend to top out when the VIX readings are low and bottom out when they are at extreme highs.

Low readings on the VIX have tended to coincide with near-term tops in the S&P 500

Source: Thomson Reuters Datastream

Low readings on the VFTSE have tended to coincide with near-term tops in the FTSE 100

Source: Thomson Reuters Datastream

Have a plan

This can be seen by returning to AJ Bell’s work on daily index movements.

In the case of the S&P 500 and the FTSE 100, the indices do very well when volatility is falling and when it remains subdued for a while (even if those with short-term time horizons might ponder selling during periods of unusual calm).

A sudden spike in volatility from the lows tends to be a warning of trouble ahead before a final panic signals a major sell-off (and a potential chance to buy, for those with iron nerves who can afford to take the risk).

The S&P 500 does best when volatility is declining, worst when it is developing and building to a crescendo, if history is any guide

Source: Thomson Reuters Datastream

The FTSE 100 has shown the same pattern as the S&P 500 over the last two decades when it comes to performance and volatility

Source: Thomson Reuters Datastream

The bad news is volatility is spookily low. The good news is we have not seen any increase in it (yet), so if history is any form or reliable guide a smash is far from imminent.

But any sudden increase in daily index movements could be a helpful warning of more difficult times ahead, suggesting that it may be time to lock in profits and take risk off the table (or at least stop taking more risk for those with a longer-term time horizon).

Looking ahead

The final question to address is what – if anything – can spark an upsurge in uncertainty and therefore volatility?

Advisers and clients must clearly keep an eye on the North Korean situation, as well as the Brexit talks in Brussels and NAFTA trade negotiations between the US, Mexico and Canada.

The US third-quarter reporting season which begins in October will be a key test of corporate health, as will the trading updates due from FTSE 100 firms in the fourth-quarter ahead of the calendar year end.

There are also a number of particular dates in 2017 which advisers and clients might like to bear in mind, with the US debt ceiling deadline on 29 September perhaps the most pressing issue, given the volatility caused by this issue in 2011 (when rating agency S&P downgraded US debt to AA+ from AAA) and 2013.

11 September Second Reading of the UK’s European Union (Withdrawal) Bill 2017-19 and subsequent Parliamentary vote
14 September Bank of England monetary policy decision
21 September Bank of Japan monetary policy decision
23 September New Zealand parliamentary election
24 September  German Presidential election
1 October  Catalan independence referendum
15 October  Austrian parliamentary election
26 October   ECB monetary policy decision (the consensus view is President Draghi may announce plans to start tapering QE at this meeting)
31 October Bank of Japan monetary policy decision
1 November   US Federal Reserve monetary policy decision
2 November    Bank of England monetary policy decision
13 December US Federal Reserve monetary policy decision
14 December   ECB monetary policy decision
14 December  Bank of England monetary policy decision
15 December Temporary deadline extension for US Federal debt ceiling expires
21 December Bank of Japan monetary policy decision
AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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