In the world of finance, the insatiable demand for content means that even when not much is happening, it becomes a topic of conversation.
Several people have noted that even the traditionally quiet summer period has been more quiet than usual this year. Current levels of rolling thirty day volatility are lower than they have been on average over the last twenty years.
And this isn’t just because it is summer. For the US equity market, end of August volatility is at its lowest for each of the last forty years.
As human beings it is tempting to conclude from this that we are ‘due’ a market crash. Part of this reasoning is similar to the gambler’s fallacy: just as we are tempted to think that a coin toss is more likely to come up heads after we have flipped eight tails in a row, so we think that a crash becomes more likely after a period of calm.
This logic can be largely dismissed. But what if there is more to the argument, for example in the view that low volatility is a symptom of ‘complacency?’
Proponents of this view tend to focus on low levels of indices like the VIX (which measures volatility implied by option prices for the US S&P 500 index) and the MOVE index (which does the same for US Treasuries). These too are at very low levels.
Matt Levine at Bloomberg has written a clear article on why the VIX should not be taken as a measure of complacency. Because the options used to calculate them have fairly short maturities they tend to reflect recent history more than expectations about the future.
That the VIX is unhelpful for predicting returns is borne out by a simple test of history. The chart below shows the last twelve times that the VIX fell below 12% and the subsequent returns over the next 120 days.
So, just as low trailing volatility appears to tell us little about market timing, there is little to show that the VIX is a valid indicator of an imminent crash.
What does complacency mean anyway, and are there any signs of it today?
Behavioural finance is littered with vague terms for forces that are hard to define. ‘Complacency’ falls well into this camp, and means different things to different people
Does complacency mean that other investors have overly optimistic beliefs about the long term prospects for an asset? Or does it mean that they are more likely to be ‘spooked’ if short term volatility proves to be higher than expected? We should be worried about the former but not the latter, and it seems to us that the environment today is far more pessimistic than optimistic.
Clients we meet with are still deeply concerned about volatility and deeply pessimistic about growth. This attitude appears to be reflected in the latest US American Association of Individual Investors survey, where bullish sentiment is at its lowest since the mid-1990s.
Similarly, there continue to be net outflows from mutual and exchange traded equity funds in the US.
The latest Bank of America fund manager survey of professional investors also reflects bearishness.
To quote from the report:
- Net overweights in equities have halved to a net 21 percent from December’s net 42 percent, while bond underweights have retreated
- Cash balances have risen since 2013 and are at levels similar to the peaks in 2008, 2011, and 2012
- Bearishness towards Global Emerging Markets equities has increased to a record level
- More respondents now think global profits will decline over the next 12 months than increase, the first negative reading in over three years
- There has been a steady rise in the number of managers taking out protection against sharp equity falls in the next three months
And finally, in options markets, although implied volatility is low the CBOE SKEW index (which the CBOE argue reflects investor fears of extreme events) is elevated.
The elephant in the room: central banks
Very few discussions of asset pricing go far before it is asserted that all price action since the financial crisis is driven by central banks. It is common to hear the argument that asset prices have been held up and volatility held down, by central bank policies. In this view, sentiment is irrelevant because investors are being ‘forced’ to hold assets.
History is in the eye of the beholder of course. However, when it comes to volatility in stock markets, evidence in favour of this argument is not obvious. In the US volatility has reached its current lows long after QE ended, and after policy has begun to tighten.
In Europe, where policy is still easing, it is hard to see a pattern:
Nor is there clear suppression of volatility in Japan. Where QE has been the largest:
A study published this summer also suggested that stock volatility is relatively unchanged since 1940 when measured on a monthly basis, but has actually increased since around 1970 when looking at the average daily moves. As is often the case, it would seem that arguments about central bank influence on volatility reveal more about the ideology of the arguer than the facts themselves. If anything the fact that these arguments are being made only supports the assertion that investors are far from complacent.
Complacency is hard to define and harder to measure, and for investors only has limited use as a concept. We need to remember that investing (as opposed to speculation) is ultimately about our own beliefs regarding whether we are being sufficiently compensated for risk. The over-optimism of others is relevant only in so far as it manifests itself in valuations, or in how it can shed light on our own motivations.
Recent focus on low volatility and complacency is in some respects driven by the need for media and other market commentary to provide content, and wanting ‘something else’ to happen now. If it reveals anything, it is the prevailing underlying sentiment that that ‘something else’ will inevitably be negative for equities. That in itself is interesting: actual complacency towards equities is non-existent; while very few people are discussing complacency towards those government bonds where the compensation for risk is lowest.