Most storms invade quiet skies, but not every calm spell directly leads to a storm. This is true in markets as in weather, which makes it tricky to interpret the subdued behavior of stocks so far this spring.
Volatility has ebbed dramatically over the past two months — both the actual day-to-day movement of the market and the expected jumpiness over the next month that's priced into index options, as measured by the CBOE's S&P 500 Volatility Index (VIX).
The VIX has been plumbing 10-month lows, sliding below 14 on Tuesday for the 13th time in the past 20 trading days, after spending most of January and February above the long-term average of about 20. In general, the VIX rises as the falls and anxiety builds, and drops when stocks rally and nerves are soothed.
The "low" level of the VIX draws predictable cries that investors are "complacent" and the market vulnerable to a serious drop. But the VIX has declined for legitimate reasons. It's not all that low and even prolonged stretches of suppressed volatility don't necessarily lead to quick tumbles.
First, consider what has drained volatility from the markets, aside from the rally in equities themselves:
- The "macro shocks" of the August to February period have passed. Indicators of emerging-market financial stress, capital flight from China, liquidation of oil stocks and other disruptive trends have eased for now. Yes, the "Brexit" vote is next month and the U.S. election campaign will get even noisier. But the Federal Reserve has retreated from imminent interest rate action and the economy is back on its "slow-and-boring" path.
- With oil up big off its lows, the dollar pulling back from highs and credit markets firmer, few major asset categories are trading near a recent extreme. The exception: negative or ultra-low government bond yields, which in the short term seem to act more as anesthetic than irritant.
- The actual, demonstrated volatility of stocks has fallen sharply. VIX and other instruments priced largely off the actual, recent trend in index movement, and it's been remarkably tame. The S&P 500 has been captive within a 3 percent band since mid-March. In fact, "realized" volatility — the measure of recent index variability, has been well below 10, so a VIX near 14 is trading at a significant premium to the market's actual behavior.
It's normal for VIX — which tracks the price of insurance — to stay higher than realized volatility. Bill Luby, a veteran options trader and keeper of the VIX and More blog, points out that over its long history, the VIX has indicated that the S&P 500 would be about 26 percent more volatile than it actually has been. Even so, the current premium of the VIX appears quite wide, based on history, which could even suggest that it's "too high" given recent market conditions.
- A final factor keeping volatility in check: Different sectors and stocks have been moving more independently rather than as a unified mass. Rotation among groups of stocks has been pronounced, with defensive and cyclical sectors alternating leadership. This to-and-fro to some degree balances the index and keeps it from jerking around as wildly.
Even if there are good fundamental and mechanical reasons for the recent VIX retreat, what can it tell us about the prospects for market direction?
It actually does not say all that much, until the VIX bottoms and decisively turns higher.
Three of the last 4 times the VIX has averaged less than 14 for about a month, dating back to late 2014, stocks have skidded into a correction. And even absent an imminent correction, it can mean the market is a bit overbought and in need of at least a rest or modest pullback.
Yet over a longer timespan, the so-called fear gauge spent prolonged stretches of time in this zone while the market managed to grind its way higher. Tellingly, this was the case around this time of the year in 2013, 2014 and last year. It's also true that after a period of elevated volatility — such as we had from August through February — there tends to be a somewhat drawn-out phase of subdued markets, as if a fever has broken.
The VIX operates best as a signal of excess complacency when it's confirmed by other sentiment indicators suggesting overconfidence. That's not generally the case right now. There were many days of heavy demand for protective put options heading into Tuesday's 1 percent S&P 500 rally. Investor surveys show the crowd to be more comfortable with stocks up a bit on the year, but not yet overly optimistic. Retail equity funds have seen significant outflows in recent weeks, implying continued caution toward stocks by the public.
Many traders also monitor the price relationships of VIX futures — which are contained within such popular exchange-traded instruments as iPath S&P 500 VIX Short-Term Futures (VXX) — for clues about possible volatility spikes. Currently, they aren't flashing noteworthy warning signs.
The market never clearly expresses its intentions in advance, of course. Stocks are in a zone, near 2,100 on the S&P 500, that has thwarted progress for the better part of two years. Shares are also near the upper end of this bull market's valuation range. Nothing extraordinary needs to go badly for this rally to be tested strenuously.
Yet while the VIX will likely be low ahead of such a test, the simple fact of low volatility doesn't mean one is imminent.