Does low volatility mean we're heading for a crash?

Scott Longley

a wooden chair in a field

The hackneyed trope from old westerns of a group of cowboys sitting around a fire while unseen enemies approach their encampment comes when one character emits the deathless phrase 'it's quite out there… too quiet'.

So it is with the measures of volatility in stock markets. To date in 2017 only on seven trading days we have seen swings of more than 1% in the S&P 500, says Alex Scott, deputy chief investment officer at Seven Investment Management (7IM).

"To put that into perspective, in the average year since 1950 there has been 49 days where the S&P 500 has moved more than 1%" he adds. "This gives a good illustration of how unusual current conditions are."

Scott points out that we have to go back to the 1960s to see similar becalmed periods.

Even just in terms of the most recent pullback of over 5% - a mini-correction - he says it is now well over a year since this last occurred. "There are only three periods before when the S&P 500 has seen a longer streak of trading days without falling 5% going back to 1950 - twice in the mid-nineties and once in the mid-60s."

The markets equivalent of the 'too quiet' warning came from Hugh Hendry, the founder of the hedge fund Eclectica Asset Management who announced via an open letter that he was closing his fund in September in part due to the "strange environment" at present where "in the absence of any recognisable asset bubble, risk assets should continue to trend positively."

"This is simply not a good time to offer a risk diversifying portfolio," he added.

Risk on

"Theories abound as to why stock movements are so calm, but, as ever in markets, there is no definite explanation for precisely why what's happening is happening," says Scott. "Some point the finger at Quantitative Easing (QE), with central bank action dampening market volatility - why worry, if Draghi and Yellen have got your back?"

Yet other still suggest that investors, scarred by the recent enough experience of the 2008 financial crisis, are still under-risked and, as Scott puts it, "wary of the next crash."

"As that fails to occur, and the equity market bears give up on waiting for disaster, there is a ready supply of buyers for every market dip, no matter how small."

Such is the view also of Sean Corrigan, director of Cantillon Consulting and ETF Stream columnist who suggests that the so-called search for yield is driving forward what has been called the most unloved bull market in history.

"My take is that the sheer weight of money swilling around searching for an outlet has conditioned everyone to think dips do not trigger bigger liquidations, but only offer fleeting opportunities for the disappointed sceptics to get back in."

It is a trend that will likely only increase in the coming weeks as November progresses and the book-closing (or ex-dividend date) draws closer. "This is something that might only get worse over the next few weeks as everyone tries to get loaded up on winners and get back to benchmark."

But while, as Corrigan suggests, these supposedly benign conditions "can't last forever", it can be very painful for any investor who, as with Hendry, believes they can run counter to the tide or predict when the tide might turn.

"We are already very familiar with this dilemma," says Scott from 7IM. "Our portfolios are currently tilted somewhat towards a cautious stance, as we try to balance a fairly benign economic environment against rather demanding asset valuations.

"Observing today's dead calm in markets gives us no particular insight on when the financial weather will change, but reminding ourselves how unusual current conditions are helps us to be prepared for the inevitable when it does come."

The fix is in

It may be inevitable, but that was not enough for Hendry at Eclectica who has called it a day. However, in his final words to investors before signing off, he did offer one more piece of volatility-related advice - look at fixed income.

He said because the market was currently underestimating global inflationary pressures - and the potential for more rate rises on the part of the Federal Reserve - it meant that the implied volatility on 10-year swaps currently represents a low-cost entry point.

"Fixed income volatility really has only one direction it can go," he told his clients. "It has over shot to the downside."

The same might eventually be said about equity market volatility. Are we heading for a crash? No one is quite sure, but it is fair to say that in many quarters the wagons are circled in preparation for more tempestuous times.


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