It’s real quiet, says the cowboy, as a tumbleweed drifts by. “Yeah . . . too quiet,” comes the reply, just before the men in the black hats burst out of the ravine, guns ablaze. The familiar trope (repeated in adventure stories of every flavour) sums up a popular interpretation of historically low volatility across financial markets.
The Vix index, which measures the expected volatility of the S&P 500 stock index, touched multi-decade lows this week. Actual, as opposed to expected, volatility has been historically low as well. The calm extends across other global markets. Investors anticipate very little in the way of market violence in the near term. Surely, then, a long bull market has bred a lazy complacency, which will encourage the reversal that will inevitably come.
Well, no. The Vix, and measures like it, are coincident rather than leading indicators. There is little evidence that, when the expected volatility is low, future investment returns will be especially poor. Yes, in the past, long periods of low volatility (the middle of the past decade, for example) have sometimes preceded market corrections. This is tautology: in markets bad things are by definition preceded by things that were not as bad.
The Vix is determined by what investors are willing to pay for short-dated put-and-call options, which can serve as insurance against market swings, up or down. A low Vix simply means it is cheap to buy such insurance because the market is putting a low probability on such swings. So it makes reasonable sense to treat a low Vix as an indicator that investors in US stocks are not nervous. But we knew that already. Stocks have been very expensive, relative to fundamentals such as profits and asset values, for some time, and have become more so of late. When investors are willing to pay more for stocks, they implicitly have a brighter view of the future.
The interesting question is not whether the eerie calm is in itself an indicator that some market monster is about to jump out and shout “boo” (it is not) but whether it is rational, given everything else we know, to expect the calm to continue.
In one sense, it clearly is rational. Market moves are not independent; they follow trends. If markets were calm this week, that makes it more likely that they will be calm next week. At some point the current trend will end, of course, but trends are more likely to continue than not.
There is another way the assumption of continued calm in the near term makes sense. The world always feels like a crazy place. But on a number of fronts, things are improving rather than getting worse. We are enjoying a broad, if not deep, global economic upswing, which is not too strong to spook central banks into a sharp rate tightening cycle. The political situation in Europe, where destructive populism recently seemed to the have the upper hand, is stabilising. Corporate earnings in the US are growing nicely. President Donald Trump’s most damaging economic instincts seem to have been foiled by a combination of realism and incompetence. Yes, his worst political impulses are alive and well, as demonstrated by his firing of the FBI director this week. Even so, how these impulses might derail the market is not obvious.
So: the trend is good, and the fundamentals are improving. All else being equal, this should support stock prices. But neither fact should distract from the reality that those prices are very high already — or the fact that high valuations do not need good fundamental reasons to revert towards to more normal levels. The stock market is not spookily quiet. It is spookily expensive.
This editorial has been subject to a correction.