The Risk in Low Volatility

August 20, 2012

The lack of volatility may also reflect a general lethargy among investors, the idea that, if nothing is going on then they don't really need to do anything.

-David Kelly, chief market strategist, JP Morgan Funds

The Risk in Low Volatility

Market volatility has fallen sharply in the last few months and on Friday, the VIX index closed at 13.45, its lowest daily close in over five years. This lack of volatility is in part due to a rising stock market - stock markets, like roller-coasters, tend to be noisier on the way down than on the way up. 


It also may reflect a global financial environment where tail risks appear to have diminished. Most notably, the ECB's explicit determination to protect the Euro (and implicit goal of holding peripheral bond yields in check) has limited, for now, the potential for a financial melt-down from the European debt situation. Global energy supplies are less stretched than a few years ago, although still threatened by the Iranian situation.  Finally, worries about a U.S. "double-dip" recession have proven unfounded for a third summer in a row as good numbers last week on retail sales, building permits and unemployment claims have reinforced the theme of steady economic growth. 


Numbers due out this week shouldn't change this story, with Existing Home Sales, New Home Sales and the FHFA Home Price Index all confirming the housing recovery, while the Markit PMI and Durable Goods reports should point to continued weakness in U.S. manufacturing.  Flash PMI reports from China and the Euro Zone are expected to show weakness but not collapse in global manufacturing while the CBO's new numbers on the deficit could help renew a focus on the "fiscal cliff" issue. In short, the information flow shouldn't heighten tail-risk fears.        


However, the lack of volatility may also reflect a general lethargy among investors, the idea that, if nothing is going on then they don't really need to do anything. This would be true under two conditions: first, if markets in general were close to fair value and second if investors in general were close to their appropriate strategic portfolios. 


However, with the earnings yield on stocks still far above the yield on high-quality corporate or Treasury bonds, stocks still look very cheap relative to fixed income. Meanwhile, in the first seven months of this year, the gap between inflows into bond funds and outflows from equity funds was wider than in any of the last five troubled years. In other words, valuations are at one extreme and investors are still steadily moving in the opposite direction.


It is one of the many ironies of finance that investors feel they should "do something" in big market selloffs, when the best advice is probably to sit tight.  Conversely, when markets are quiet but still out of balance and investors should be more aggressive, they are at best passive and at worst move in the wrong direction. The week ahead should be a quiet one - that does not, however, mean investors should feel comfortable having increasingly "risk-off" portfolios in an increasingly "risk-on" world.


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Wednesday, August 22nd


Existing Home Sales                                 Forecast         Last

  Sales, mils, ann rate                                4.550              4.370

   Inventories, mils                                    2.510              2.390


CBO Mid-Year Budget Review           


Thursday, August 23rd