Why Low Market Volatility Won’t Be Sustained

by Serge Berger | March 5, 2012 1:16 pm

By now, even the most peripheral market participants have likely noticed the decrease of volatility levels so far in 2012. To shine some more light on today’s low-volatility levels in risk-asset markets, however, let us walk through a few charts (all charts below courtesy of Bloomberg Finance).

Large-cap stocks — as collectively tracked by the S&P 500 Index (SPX[1]) — have rallied almost 14% since December 20 and are up nearly 25% from their early-October 2011 lows. Of note is that the rally since December 20 has come in one straight shot (i.e., with no pause).

While the rally came on the back of further liquidity injections by central banks around the globe, investors were forced to embrace it to the point of sending volatility to levels not seen since July 2011. This trend is illustrated by the declining slope of both major volatility indexes, the CBOE SPX Market Volatility Index (CBOE:VIX[2]) and the CBOE S&P 100 Index (OEX) Market Volatility Index (VXO[3]).

As their names imply, the VIX and VXO track implied volatility in, respectively, SPX and OEX options. What this likely means is that many market participants are currently running around “naked” without much downside protection in terms of put options on stocks.

Daily chart of VIX and VXO
Click to Enlarge

One way to point out the decrease of actual (historical) volatility in the S&P 500 is by noticing the index’s narrowing trading range. As of Friday, March 2, there has not yet been a single day this year where the S&P 500 dropped more than one percent; every single attempt at a dip has been bought.

Chart of SPX Narrowing Trading Range
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Another way of looking at the lack of volatility in equities is via the average true range[4] (ATR). Much like the VIX, the 10-day average true range of the S&P 500 has been in a steady downward trot and the current level of 10.54 was last seen in the spring of 2011. Given the still very shaky macro backdrop (last week’s global macro data came in below expectations on average[5]), this trend of narrow intraday swings in stocks is remarkable (and most likely unsustainable).

Chart of SPX Average True Range
Click to Enlarge

Commodities saw a rise in volatility last week but their volatility already started slowing its downtrend in the middle of February. Volatility in stocks, on the other hand, has continued to fall considerably all through last week. Volatility readings in certain commodities and currencies have a tendency to shift ahead of volatility in other asset classes, namely stocks. As such, we must keep a close eye on how commodities trade in coming days.

Commodity Volume Versus Equity Volume
Click to Enlarge

All in all, the current low-volatility levels in equities is unsustainable, especially if we consider how negative investor sentiment was just two months ago. Volatility is a mean-reverting asset as they say, and as such, a move higher in volatility should not be far away.

  1. SPX: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPX
  2. VIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VIX
  3. VXO: http://studio-5.financialcontent.com/investplace/quote?Symbol=VXO
  4. average true range: http://www.investopedia.com/terms/a/atr.asp#axzz1oGRqdu58
  5. came in below expectations on average: http://www.reuters.com/article/2012/03/05/markets-global-idUSL2E8E560R20120305

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