It’s the trillion-dollar question: when will volatility return, and what will be the cause?
The unprecedented calm of the U.S. stock market has been one of the most notable trends of 2017. September featured a stretch of the quietest trading in history, while the S&P 500 SPX, +0.12% has only closed with a 1% move eight times this year, on track for the fewest since 1995, per LPL Financial data. Perhaps most notably, the CBOE Volatility index VIX, +1.26% has almost unceasingly traded below 10, representing half its long-term average, and it dropped to a record low earlier this year.
In one of the most telling stats about the current environment, the VIX only settled below 10 nine times before 2016 (it was launched in the early 1990s). Since then, according to data provided by Natixis Global Asset Management, it has done so 26 times, including on Wednesday.
The market action has raised plenty of questions about whether the lack of fear is justified by positive tailwinds—such as improved earnings, economic data, and the prospect of tax-reform legislation in Washington—or whether it is a sign of complacency on the part of investors. One thing experts do agree on, however, is that the current environment won’t last forever.
“Low-volatility periods like this one are invariably followed by bouts of high volatility,” said Alex Healy, deputy chief investment officer at AlphaSimplex Group. “Some catalyst will get investors spooked, and it may seem small at first, but it only takes one animal to start a stampede.”
There have been other stretches where the VIX trades below 20 for extended periods, including in the 1990s, in the lead up to the dot-com bubble bursting, as well as in the mid-2000s, in the lead up to the financial crisis, as seen in the following chart by Project Syndicate.
Stocks have shown an uncanny ability to shrug off all manner of uncertainty, including massive hurricanes in the U.S. and a tense geopolitical environment marked by escalating threats between the U.S. and North Korea. Despite those issues, major indexes like the S&P 500 and the Dow Jones Industrial Average DJIA, +0.09% have hit dozens of all-time highs.
“For all the tectonic shifts we’ve seen over the past year, the market hasn’t really been reacting,” said Alex Piré, client portfolio manager at Seeyond. “I don’t know what will cause volatility to return if everything that’s happened over the past year hasn’t resulted in it already.” He added that geopolitical issues and concerns over economic growth in China were the usual suspects mentioned on this topic, while a shrinking of the Federal Reserve’s balance sheet could be another factor.
If volatility does return, it may not even be caused by a single event that results in a violent market action. Instead, it could gradually rise as investors become more concerned about equity valuations or other factors in the market.
According to a Natixis analysis, when the VIX reaches a low, it typically takes a month for it to return to its average levels. It can then move as high as 30 over a more gradual period, one that can take four months at a minimum, or as long as a year and a half.
“It won’t spike up just because low volatility is unsustainable,” Piré said.
Among popular exchange-traded funds that offer low-volatility strategies, the iShares Edge MSCI Min Vol USA ETF USMV, +0.22% has seen inflows of $69.81 million over the past month. The PowerShares S&P 500 Low Volatility Portfolio SPLV, +0.30% has seen inflows of $89.58 over the same period, including inflows of $128 million over the past week alone, enough to turn its year-to-date flows positive.
“This money is dwarfed by the flows into broad-based market strategies, but it shows that at least some investors aren’t complacent, that they’re positioning for what could come,” Piré said.