Fear. It is one of the prevailing themes Wall Street is focusing on as they survey a U.S. stock market that has staged a steady, albeit measured, assault on all-time highs over the past few months and as President Donald Trump settles deep into his chair in the Oval Office.
Nicholas Colas, chief market strategist at Convergex, told MarketWatch that hand-wringing about risk in the stock market amid growing political concerns is among the topics most frequently cropping up in discussions with clients, even as the Dow Jones Industrial Average DJIA, +0.19% S&P 500 index SPX, +0.02% and the Nasdaq Composite Index COMP, +0.19% hit records. “The effect President Trump is having on capital markets is the first thing clients want to talk about. For many, it is the only thing,” Colas told MarketWatch.
So, why is the CBOE Volatility Index VIX, -0.70% or VIX, otherwise known as Wall Street’s fear gauge, hovering around historic lows, highlighted by a fleeting lurch down to a 10-year nadir of 9.97 on Feb. 1.
What is volatility anyway?
First, it is important to define our terms. On Wall Street, “fear” can be a subjective term because the idea of an asset suddenly jolting up or down could result in painful losses for investors betting on price moves. But typically when the market refers to “volatility” they are describing an assets’ likelihood of swinging higher or lower. (We’ll touch on two other terms that tend to be used in the market interchangeably later: risk and uncertainty).
More specifically, the VIX measures the implied volatility of S&P 500 index options over a 30-day period in the future. In other words, the VIX isn’t about current levels of fear but about the market’s wager on how far the S&P 500 could move from current levels over the next month, so various options can be priced appropriately.
The historic, long-term average of the VIX is around 20, with its current level near 11 representing an uncharacteristically subdued reading (see chart below). Low levels in the fear gauge usually coincide with rising equities, which is currently the case.
Since share prices often fall faster than they rise, a low VIX implies that more investors are expecting prices to extend gains, which means that an unexpected shift in sentiment spurred by a market surprise could catch investors off guard and upend stock-market indexes. Currently, investor sentiment remains near a three-year high.
Yet, a laundry list of potential land mines abound. Trump’s election victory and his first few weeks in office have certainly stoked a degree of uncertainty—and so-called animal spirits)—about his policy positions. Combine that with worries about European financial markets and concerns about growing populism in the region and there appears to be no dearth of powder kegs for the market. Indeed, measures of economic uncertainty are near an all-time high.
But the market certainly isn’t exhibiting definitive signs of fretfulness. And that can be judged by a number of stock-related metrics. Let’s take the S&P 500’s standard deviation over the past few weeks. Standard deviation is a way to look at the average price performance of an asset and determine if it has deviated from a particular range, to gauge historical, or actual, volatility.
As the chart below shows, the stock market has made some major swings since August, but has traded in a relative narrow band in recent months (see area highlighted by the read circle below):
Another measure of volatility, stock-market volumes, also reflect a period of quiescence. As MarketWatch’s Wallace Witkowski has explained in a previous piece exploring measures of risk, high volume and high volatility tend to be interrelated. But as recent action suggests, volumes have been tepid, at best:
If Wall Street’s fear gauge, volumes and standard trading ranges point to placid markets why are investors so apparently fixated on fear?
Interpretations of risk and uncertainty
Colas offers a fairly simple explanation for this.
“The equity market feels very strongly that they have [Trump] figured out and to some degree that is fair because he was very clear on the campaign trail as to what he wanted to do and he is executing on that plan,” he said. Trump has signed about 20 executive orders which have been in line with his hard-charging campaign pledges on everything from loosening regulations on Wall Street to restricting immigration from seven majority-Muslim countries.
That said, fears the VIX could suddenly spike on the back of an unexpected event don’t seem remote. Colas says he believes that the current level of the VIX is more anchored to “everything we knew before the election and about the fourth-quarter corporate results [which have been OK].” Which underscores the point that the VIX is rooted in historical volatility. Therefore, a truly new event could scare up implied volatility.
And then there’s the question of whether investors are thinking about risk the right way? Steve Barrow, head of strategy at Standard Bank, describes it this way in a Tuesday research note:
Risk and uncertainty; two sides of the same coin? It might seem reasonable to think so, but if we look at the current situation it seems to us that there is a large amount of uncertainty—but little risk. What leads us to this view? Anecdotally, it seems to us that events such as Brexit and Trump’s victory last year in conjunction with upcoming events such as elections in a number of eurozone countries, has led to a good deal of uncertainty. We don’t know how electors will vote in Europe given the opinion poll mistakes of last year. We also don’t know for sure how the policy makers that won—Trump and the Brexiteers—will use their victories. But does that mean that there is lots of risks? It would seem so, but while measures of uncertainty are high, measures of risk seem quite low.
Barrow recalls what happened last year when the U.K. voted in June to leave the European Union and Trump squeaked out his presidential victory in November:
When the ‘remain’ side lost uncertainty (over the outcome) became a certainty and risk measures soared. It was the same with Trump’s win in November. Looking ahead to possible black swan events this year, such as a [Marine] Le Pen victory in the French presidential election, there is a degree of uncertainty but, as yet, little sign of risk.
Alternative measures of risk
There are certainly assets that reflect a level of unease in the market, outside of the VIX and stocks.
Gold futures GCJ7, +0.28% viewed as a haven in a time of uncertainty have been climbing recently. Gold prices touched their highest level in about three months on Monday. Gold for April delivery is up about a 1% this week, and 7% over so far this year, compared with a 2.4% rise for the S&P 500 in 2017 and a 1.5% rise for the Dow, according to FactSet data as of Feb. 6’s close.
To be fair, gold may also be climbing as expectations for inflation grow. Gold is often used as a hedge against inflation.
Meanwhile, currencies also have been prone to bounciness. Look no further than the gauge of the U.S. dollar, the ICE U.S. Dollar Index DXY, +0.50% as an indication of volatility. The dollar index, which measures the dollar against a basket of six currencies, has seen some sizable swings in light of Trump’s policy pronouncements and recent comments that the greenback was “too strong.” (see chart below):
Other currencies like the Mexican peso USDMXN, +0.0189% have seen up-and-down trade on Trump comments, given his threats to build a wall along the U.S.-Mexico border and orders to rework longstanding trade pacts.
Watch the VIX
But for investors watching the VIX, market technician John Kosar at Asbury Research tells MarketWatch that he’s looking for a sustained level of the gauge at around 12.20 as a sign that fear is genuinely creeping higher. That is far from the traditional view of 20, which has usually implied fear is gripping the market, but at this juncture that’s enough to catch Kosar’s attention.
“There are potholes all over the road,” Kosar said, referring to the market risks. But he said the market needs to go from “complacent to sustained fear.”
“You need to watch your p’s and q’s. The market is a little too fearless right now. When market metrics indicate that investors collectively are not worried that is precisely when smart investors should be cautious,” he said.
Investor takeaway: If you’re in the market for the long-term, discussions about risk and volatility may not be meaningful (assuming you aren’t at or near retirement age), unless there is an expectation of catastrophic losses. So, while it is important to be aware of shifts in market sentiment or risks, even when markets nosedive, it’s important to remember they have a tendency to recover.
Colas said 1968 offers a good proxy for the current situation. Despite wide-ranging political tumult at the height of the Vietnam War, the S&P 500 generated a return of roughly 11%. Back then the biggest driver of the market were corporate earnings and interest rates. That is all the market really ever cares about, Colas said.
The same should hold true now.