When you’re watching horror movies, the time to worry is when things become eerily quiet. Last Friday, the market’s own measure of fear, the Chicago Board Options Exchange Volatility Index (VIX), hit its lowest level since last July. This is the financial equivalent of eerily quiet.
The VIX tracks the implied volatility on S&P 500 options. When investors are nervous, they’re more likely to purchase put protection, driving up the cost of options and implied volatility in the process. When markets are calm, or investors are too complacent depending on your point of view, the VIX tends to sink back into the teens.
At its current levels around 17 and 18, the VIX is modestly below its long-term average of 20 and is well below its 2011 peak of nearly 50. It’s also below the mid 30s it hit in October, when I argued that the VIX was too high and would likely moderate towards the high 20s or low 30s.
But while the VIX should certainly be lower now than it was six months ago, I believe its current levels seem too low. While market conditions have certainly improved since the fall, it looks like investors may have become a bit too at ease. With the risks to Europe lingering and most of the world still stuck in a lackluster recovery, a bit more caution — or fear — may be warranted.
Historically, economic activity, credit conditions and market momentum are three key drivers of implied volatility. All three have improved in recent months. Leading indicators have risen, market momentum has improved and credit spreads – measured by the spread between the 10-year note and an index of high yield bonds – have contracted by around 1%. Thanks to the improved general market environment, the VIX should certainly be lower than my October forecasts. However, in my opinion, a fair current value for the VIX would be around the low to mid 20s, higher than today’s levels. And unless we see a further acceleration in the economy and more spread tightening, I would expect volatility to post a modest rise in the coming months.
So assuming that volatility is set to rise, how should investors adjust their portfolios? First, remember that it’s the change in, not the level of, volatility that tends to impact asset prices. In an environment of rising volatility, investors would want to modestly lower their weight to market segments that are very sensitive to changes in volatility and raise their weight to less sensitive or lower beta instruments.
Practically, this could mean a modest reallocation out of high-yield fixed income towards investment-grade bonds, an asset class that currently appears to be a better relative value (potential iShares solution: LQD). While the spread between high yield and Treasuries has contracted by roughly 200 basis points since September, the spread between Baa bonds and Treasuries has been stuck at approximately 325 bps. Investors may also want to consider modestly increasing their weight to mega-cap equities. This segment of the market still trades at a significant discount to the broader market and is less sensitive than other segments to changes in volatility (potential iShares solutions: OEF, IOO, IDV, HDV).