Today’s market volatility is extremely low. In fact, over the past 50 years, there have been only two other periods—the mid ‘60s and 1994—where realized volatility for the S&P 500 was at or below current levels.
We believe there are several conditions that have driven volatility to artificially low levels.
For starters, the market structure has changed significantly. Passive and quantitative investing accounts for about 60% of trading volume, according to recent JPMorgan research, which has more than doubled during the past 10 years. In addition, only about 10% of trading volume is driven by fundamental, discretionary investors. In such an environment, prices may significantly deviate from fundamental values, which can create opportunities for fundamental investors.
In general we don’t believe we’re in a benign macro environment. We believe several developments are keeping volatility down.
Nevertheless, current prices and low volatility suggest that the market thinks it’s in a benign macro environment. Yes, several of the larger macro risks have faded for now, but in general we don’t believe we’re in a benign environment. We believe several developments are keeping volatility down.
In the current low interest rate environment, yield is scarce and, as a result, investors are selling volatility to try to capture the premium between the implied volatility being priced into derivative contracts and expected realized volatility. The high volume of this trading strategy has dampened volatility.
While the quant-driven sector rotation is driving correlations down, it is also bringing risk down. As rules-based market participants move from energy to utilities, utilities to discretionary, discretionary to IT, it’s suppressing correlations between these sectors.
Lastly, in an environment of low volatility combined with price momentum, there tends to be highly leveraged, systematic investors buying into the market as it moves up. That’s consistent with the quant activity that’s happening today, and inconsistent with fundamental investing. Risk parity is a good example of this type of low volatility, price momentum-oriented investing. Since the global financial crisis, risk parity has benefited significantly from this development, but at this point, we believe it’s highly exposed.
Overall, JPMorgan estimates that these activities are driving volatility down by 4%-8%.
For perspective, in the past 20 years, the CBOE Volatility Index (VIX) has been below 10% for only 11 total days—interestingly, 7 of those days have occurred since mid-May 2017.
While these observations don’t necessarily predict future events, they do highlight the uniqueness of today’s environment. And, from past experience, during sustained low periods of volatility we have repeatedly observed bad behavior by investors, such as increasing leverage and systematic (market) exposures.
We certainly are seeing some indication of bad behavior by market participants, and we don’t want to be players in that same bad behavior.