Fear gauge may be scarier than it looks

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Appearances may be deceptive when it comes to US equities.

January has been one for the bulls so far with the S&P 500 rising nearly 5 per cent and equity volatility hitting a series of new lows not seen since 2007.

At a reading of 12.69, implied volatility as measured by the CBOE’s Vix certainly suggests Wall Street’s “fear gauge” is hibernating for the winter. Interpreted another way, the low Vix is a sign of investor confidence that stocks are set to climb further, particularly when the financial system is awash with money from profligate central banks.

“Central banks are flooding the system with money and we are not seeing the danger sign of inflation,” says Vadim Zlotnikov, chief market strategist at AllianceBernstein. “Volatility is surprisingly low, but we are in a sweet spot for markets.”

Also helping depress volatility is the growing role of passive investment strategies that merely seek to follow an index, as popularised by fast-growing exchange traded funds.

But in a sign that the Vix may be misleadingly low, correlation, which tracks how S&P 500 sectors behave in relation to each other, rose over the new year to 88.5 per cent, up sharply over the past three months, according to ConvergEx.

That means investors still face a market that swings between the duelling sentiments of risk-on/risk-off and is evidence that for all the bullish talk about equities, markets have yet to fully recover from the financial crisis and extended central bank support.

This matters for investors and money managers for important reasons.

A healthy stock market is deemed one where fundamentals and economics dictate price changes, leading to divergences between industry sectors that each tend to react differently to the underlying macro story. High correlation mitigates such moves as all sectors tend to rise and fall together.

“We would love to think we will see a decoupling of correlation, but that will require more confidence in the market,” says Timothy Gould, head of US equity capital markets at Macquarie.

Barry Knapp, head of US equity strategy at Barclays, says higher option premiums for the Vix beyond one month suggests investors are mindful that correlation could intensify against the backdrop of fiscal gridlock in Washington. “The flows we see as a firm are biased to people buying Vix exposure for March and April due to the risk of a macro correlation surge.”

Correlations are not a new problem. A 1994 paper by academics at Rutgers University into stock price movements in the 1920s and the 1930s found that what the authors call “excess comovement in returns” for stocks “increased significantly during the boom and was a signal characteristic of the tumultuous market of the early 1930s”.

For today’s investors there is a similar sense of frustration as high correlation reinforces pricing inefficiencies for active stock-pickers and investors seeking to unlock opportunities.

“It’s a trend that is firmly in place and is confounding and frustrating for stock pickers,” says Jack Ablin, chief investment officer at Harris Private Bank.

As more investors buy and sell ETFs and indices, it helps maintain higher correlation between sectors.

“When you have instruments that want to mimic the market, it automatically increases correlation as you have fewer people making directional bets,” says Mr Gould.

The move towards indexing comes after active managers were beaten by the rise in markets last year. The worry is that large amounts of money moving into passive investing strategies can lead to distorted prices.

“An expensive sector can become more expensive, while a cheap sector can get a lot cheaper, testing the will of those investors that see valuation discrepancies and are trying to get in between them,“ says Mr Ablin.

ETFs are seen as having clipped the peaks and troughs of the market and thus mitigated volatility. Last week, BlackRock, the world’s largest money manager, reported net inflows of $37.5bn into its ETFs for the final three months of 2012.

Exchange traded funds had a net inflow of $189.5bn in 2012, the strongest year since 2008, according to Birinyi Associates.

“I do wonder if we are not in a structurally different era with more money moving into index products,” says Mr Zlotnikov.

A relatively benign reversal of the index trade, reducing correlation, is possible as investors focus on picking stocks that could benefit from leveraged buyouts or M&A activity. But there is a worry that the macro approach could eventually hit the wall.

“The less benign way is that volatility rises and the index approach to managing risk is no longer attractive,” says Mr Zlotnikov.

Ultimately, the tide floating all equity boats is coming from the Federal Reserve.

“The next data point that may break correlation is a change in Fed policy,” says Nicholas Colas, chief market strategist at ConvergEx.

That could entail a sharp rise in the Vix, should correlation remain high.

“I’m coming to the conclusion that these higher correlations will be with us for a long time. Most commonly, volatility rises to meet correlations, rather than the other way around,” says Mr Colas.

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