Equity Volatility is at All Time Lows
The author, explaining volatility to the kids of today.
There is no doubt that equity implied volatility is very low. As of October 13th, 2017, the VIX has closed below 10 on 41 occasions. 32 of those days have been this year. As the VIX is popularly known as a “fear index” this situation been labelled a “bubble of complacency” (which sounds like it should be located close to the sea of tranquility). This can be read as putting the blame for low volatility squarely on the shoulders of options’ traders, who actions create the VIX. But this is exactly backward. Implied volatility is low because of realized volatility being a lot lower.
But is realized volatility actually at an all-time low?
Generally, traders don’t have long careers. Bad ones lose their money or get fired. Competent ones see their specialty disappear. Successful ones end up in management. Few traders have any long term perspective. Their idea of history might be as short as five years.
I looked at 20 day realized S&P 500 volatility since 1950. This is shown in Figure One.
Figure One: 20 day close to close volatility for the S&P 500.
The overall average volatility has been 13.1% and this year it has only been 7%. So volatility is certainly at the low end. But something interesting happens if we look at the years where realized volatility was below 10. There were 23 such years. Of these, only 6 have been since 1990 when the VIX was first calculated. Before 1990, the average level was 11.7% and since it has been 15.2%.
But the typical volatility analyst looks at the VIX, and the typical option trader has a career of maybe four years. From both of their perspectives volatility is amazingly low, but an alternative interpretation is that we are going back to an older regime. Admittedly, even then, 2017 has been a low volatility year but it isn’t very different from 1952, 1963, 1964, 1965 or 1972.
What do all those years have in common? Low and non-volatile inflation. Most macro-economic statistics have a weak or non-existent relationship to equity volatility but inflation has a positive correlation. There are obvious two ways inflation could rise in the near future. The first would be congress spending a lot of money. Republican congressmen are typically only against spending when they don’t hold a majority, but this current house doesn’t seem to be able to pass any significant legislation, so I don’t see a chance for inflationary pressure from the politicians. The other potential source would be the actions of the Fed. They are clearly raising rates which is inflationary. They are the only relevant actors to watch.
- Complacency is not the issue.
- When considering the pre-VIX environment, 2017 is not a single outlier.
- The Fed is the trigger for a possible volatility increase.