Rollercoaster

While I think that market volatility will be higher in the second half of the year, the current level looks too high to me. In fact, I think that the panic is overdone unless you believe we’re headed back into another banking crisis or severe recession, both of which I would argue are unlikely.

Back in May, when the VIX Index — otherwise known as the fear gauge — was trading at around 17.50, I highlighted that it looked too low. Now, according to my latest analysis, volatility levels in the 40-plus range are way out of line compared to where leading indicators suggest they should be, and fears about equity markets appear extreme relative to credit market conditions. According to my model-based analysis, volatility should not be above 40 but rather in the mid- to high-20s, slightly higher than where it should have been in May.

Volatility tends to move with market momentum, credit spreads and leading economic indicators. My analysis compares current levels of volatility with these fundamental drivers and assigns a “fair value” for the VIX. And while all three of these drivers have deteriorated recently, none are suggesting that volatility should be this high.

For example, credit markets have seen spreads widen. However, recent widening spreads have been relatively small compared to the sell-off in 2008. Today the spread between Baa and Aaa bonds is 97 basis points, in line with the long-term average. In contrast, at the peak of the 2008 crisis, spreads were well above 300 basis points. In other words, equity market fear appears extreme relative to credit market conditions.

Similarly, while we expect very slow and potentially negative growth over the next one to two quarters, current volatility levels are way out-of-line compared to where leading indicators suggest they should be.

What does this mean for investors? While we still believe they should remain defensive, the current selling looks extreme and the recent spike in volatility appears too high.  Investors should look to add selectively to their equity exposure, while still maintaining a defensive posture.

Bloomberg: