As the stock market trades near records, it isn’t surprising to see a dramatic fall in volatility, but don’t chalk that up to complacency, says one strategist.
Strategist Nick Colas, co-founder of DataTrek, market research shop, says that despite one measure of volatility trading at historic lows—the CBOE’s volatility VIX, -2.13% —markets are anything but complacent as the so-called VIX sometimes implies.
The CBOE’s volatility index, or VIX, is based on options activity, and measures expectations for S&P 500 volatility over the coming 30 days. It tends to move inversely to stocks and because equity benchmarks tend to fall faster than they rise, the gauge is often read as a measure of expectations for coming market shocks.
VIX was down 2% on Friday and has declined nearly 15% to 9.67 over the week, trading at nearly half its historic average at around 19. The indicator is also lower on the month, down 5%. Meanwhile, the S&P 500 SPX, +0.21% climbed 0.2% to 2,602.42, a record for the large-cap index.
“While the VIX is a fine measure to assess traders’ short-term sentiment on US large-cap equity volatility, it is purposefully blunt instrument,” Colas wrote in a note to investors on Friday.
In other words, Colas argues that VIX isn’t helpful at measuring changes in volatility across a wide swath of markets and assets, where signs of jittery markets may lurk. Those include fixed income, commodities, small-cap stocks as well as emerging markets and developed European and Asian equities, collectively known as EAFE.
By looking at these separate asset classes and sectors, Colas found that volatility has actually been on the rise over the past month.
“First, overall implied volatility for the S&P 500 (looking at all expirations, not just the next 30 days captured by the VIX) is actually higher by 6.5%. Second, correlations between the various sectors of the S&P 500 and the index itself have been trending lower. That reduces overall volatility at the margin,” Colas said.
Colas says the large-cap technology sector has masked rising implied volatility. The S&P 500 Technology sector has risen 1.8% this week and is up 6% over the past 30 days. The S&P 500 has gained 1.3% over the same period.
Measures of expected volatility in nine out of 11 sectors have risen over the past 30 days, while the VIX of technology sector saw a decline in volatility of nearly 7%.
“We chalk it up to options traders reluctant to buy options [on tech sector] (and thereby bid up implied volatility) ahead of a possible year-end melt up,” Colas said.
Among international equities, VIX of EAFE (non-U. S. developed markets) stocks rose 27%, despite the fact that this group has done well enough in the past month.
Colas suggests that the reason for the jump in implied volatility is linked to the expected unwind of the European Central Bank’s asset-purchase program.
“Investors are hedging against expected future price declines in EAFE stocks as the European Central Bank starts to reduce its bond buying program. Recently, we noted in a report that the EAFE Index is just 6% weighted to Technology versus a 25% allocation in the S&P 500 and 30% in Emerging Markets. Once QE is no longer a factor in driving EAFE asset prices, there is much less fundamental growth opportunity here,” Colas said.
Implied volatility of U.S. junk bonds also rose, likely due to do growing concerns about this corner of the market. The jump was notable relative to the modest decline in underlying high-grade bonds, which fell only 0.7%.
“Recent volatility in high yield should come as no surprise,” Colas said.
That is because composition of corporate bonds is a function of issuance and not underlying financial performance. Investment-grade bonds are dominated by banking (28%), consumer-non-cyclicals (18%) and communications (13%), while high-yield bonds are heavily weighted toward communications (24%) followed by consumer noncyclicals and energy at 13% each, according to Colas.
“The top weighting in high-yield (communications) is a beehive of potential technological disruption. As for investment grade corporates, this index is strongly weighted to financials, whose fundamentals are generally sound,” Colas said.
The main takeaway from Colas is that low levels of VIX aren’t really indicating complacency in the markets.
“Like the proverbial duck swimming in a pond, there is plenty going on below the surface,” he said.