One of the concerns clients often express to their advisors is fear over equity market volatility. Last week’s bellicose warnings from North Korea have added to those concerns. By the end of last week, the CBOE Volatility Index (VIX) had moved up to close around 15% to 16%, after hovering around 10% over the past month.
Despite the North Korea-fueled uptick, equity market volatility is still relatively low, considering that as recently as January and February 2016, the VIX was regularly trading over 20% and reached a high of 40% the prior August. Given this, advisors should not be too complacent. There are sound reasons why volatility has been low this summer, and why this won’t necessarily last.
With So Much Political Uncertainty, How Can Volatility Be Low?
With equity volatility relatively low over the past six months, investors may be surprised given the Trump administration’s staffing turmoil and other political issues that unfolded during this period. In fact, the political soap opera may have actually distracted the market from economic news, keeping volatility in check.
We tend to see low volatility at times when market participants are focused on microeconomic influences, such as corporate earnings. This “bottom up,” fundamental-type news – good or bad – is released one company at a time over an extended period, therefore keeping broad equity market volatility low. As earnings come in, investors choose market sectors they like and invest in them, sometimes on a rotating basis. In this type of market, we don’t see short-term volatile moves in broad indexes.
For most of this year, macroeconomic factors have not been a concern or focus of market participants. Rates are set to rise, but investors expect this to happen very gradually. Another factor keeping volatility low is confidence that the regulatory environment is, and will remain, business-friendly. As we all know, individuals and companies are more open to making investments in a more favorable regulatory environment.
Volume and Seasonal Considerations
Another key reason for volatility staying in check is below-normal trading volume. Volatility and trading activity go hand in hand, and lower volume is a key market feature right now.
Market participants are sitting in equities, in part because the potential for rising rates is making them more cautious about fixed income investments. There’s not a pressing urgency to get in or out of the equities market. As mentioned, the micro-driven, measured buying is inspired by positive company fundamentals.
The VIX measures expected risk, out one month. To come up with those expectations about near-term risk levels, market participants tend to look at actual market volatility in recent weeks. The May through July period is historically the quietest period of the year, with a few notable exceptions. With inflation under control and interest rate increases slow and steady, investors have a hard time seeing the catalyst that will change the tone of market.
Beware of the Risks, and Be Prepared
All that said, VIX futures contracts expiring in 2018 are at prices much closer to historically normal levels – which means the VIX could be in the 16% to 17% range or higher in the next 9 to 12 months. Markets are based on perceptions and behavior: The prices for VIX futures expiring in 2018 imply that traders believe today’s low volatility won’t last much longer.
However, advisors can’t rely on the VIX to be a good predictor of future market volatility. It is a better reflection of the current broad equity risk perceptions which can shift quickly as we saw last week. As we saw just two years ago in August 2015, markets can get turbulent very quickly — too quickly for investors to alter their portfolios. An imminent North Korea attack on Guam is an example of a sudden geopolitical event that could rattle equity markets and send stocks spiraling downward. Investors should be aware that low-volatility conditions are not permanent and can change suddenly.
Portfolios need to be structured to prepare for this type of sudden volatility, which is a regular occurrence in markets. A good analogy to the dynamics of markets that we all face are changeable weather conditions. We don't build our houses for average weather. We build them for the extremes of the climate we live in. And those of us living within two miles of the beach (risk-lovers, some would say), have to build our homes even stronger, and buy costly hurricane insurance to protect against at least a Category 3 "named storm." Depending on our risk appetite, we can use the same principles in building portfolios consistent with how much turbulence we can tolerate in our investments.
Since the price of volatility is at the lower end of the range now, advisors can take this opportunity to prepare portfolios for sudden, or gradual, changes in volatility. One way is to hedge equities with put option strategies. Another is to shift into lower-risk equity strategies that have less participation in downside equity moves.
As always, in conditions like this, you might want to consider shifting to strategies that take some equity or credit risk but have higher levels of income as a part of their returns. And, of course, stay diversified across asset classes and global equity markets.
When clients call to express their concerns about volatility returning to the markets, they can rest assured that you are taking all the steps necessary to not only protect their portfolios, but make the most of volatility to help grow their assets.