Markets Too Calm? Time to Fix the VIX

As many of you know, The Chicago Board Option Exchange’s Volatility Index (better known as the VIX) is at a record low level. Long the market’s gold standard for measuring investor fear and paranoia, the VIX has been hibernating all year. This week the VIX fell below 10, its lowest closing level since December 1993 and its longest sustained stretch of calmness in 27 years. Did someone at the CBOE accidentally unplug the VIX or are we really entering an extended period of calm seas?

Most analysts and pundits expected that the inauguration of President Trump, the political neophyte and tempermental tweeter, would trigger significant volatility in the markets. Yet U.S. markets remain at or near their all-time highs. Despite the revolving door or hirings and firings in Trump’s inner circle, the markets have generally ignored Washington’s real-life reality show, North Korea nukes and a huge amount of uncertainty around global trade, tax reform, health care  reform and elections in Holland and France.

Is the VIX still relevant?

The Financial Times recently asked readers: “Should investors worry that stock market ‘fear gauge’ is so low?” According to FT, the VIX is a clean, simple gauge that tends to “follow markets rather than lead them, and does a poor job of capturing more ephemeral but very real investor worries.”

As our client, Kyle Walters, founder of Dallas-based Atlas Wealth Advisors told me, “Many investors, over the last several years, have forgotten that the VIX, and the volatility associated with the VIX, is the reason we are compensated to invest in the stock market.” Walters said we should anticipate more volatility, and know it’s a good thing.  “Over the short run, the market is unknowable; over the long run, market economics are inevitable,” Walters added.

The New York Times’ Neil Irwin recently wrote that The Stock Market Is Weirdly Calm and explained why (sort of). If the last few years have taught investors anything, Irwin argued that investors are getting smarter about jumping to conclusions: “Those with a hair-trigger reaction to political news stand to lose, while those who bet on a continued steady and unexceptional expansion will win,” wrote Irwin. “Investors learned a lesson that it’s easy to overreact to political developments, and the same seems to have happened globally in the last several months,” added Irwin.

Maybe we’re not even measuring the right thing when it comes to investor fear?

Our take: Just as today’s low jobless rate does not really account for the millions of working age Americans who have dropped out of the workforce or who are working at jobs that pay much less than they used to, the VIX may no longer be measuring the right elements of fear and uncertainty.

As Barrons’ Ben Levisohn recently wrote, Hold On! The VIX Isn’t as Low as It Looks?!?! “First of all, the so-called Fear Index isn’t measured the same was that it used to be,” noted Levisohn. “In 2014, the CBOE changed the rules for the VIX index by including weekly options in the mix. One could argue that by taking that change out of the equation, the old VIX would have been lower in 2007 and possibly 2014,” Levisohn added.

Bill Schultheis, Principal, Investment Advisor of our client Soundmark Wealth Management in Kirkland, Washington told me that the VIX, by its very nature of measuring the magnitude of the options premium on the S&P 500, “continues to be a reliable measure of investors’ expectations of market volatility, not of volatility itself. Although the financial media continues to highlight VIX, for the average investor this tradeable security is irrelevant from a portfolio and financial planning perspective,” added Schulteis.

Michael R. Gold, a Senior Private Client Advisor of New York-based Gertsein Fisher, agreed. “The VIX simply gauges the psychological state of the investor. It’s interesting that we need an indicator like the VIX to tell us investors are nervous whenever the equity markets experience any unwelcome volatility. It is pretty obvious when our screens are flashing red that people will be anxious and the VIX will spike. Sure you can look at the VIX, but you can also turn on CNBC--if the Dow is off by triple digits, then there is going to be some fear out there. Keep it simple; if it’s not simple then you are asking the wrong questions,” noted Gold.

Are investors becoming too complacent?

According to Irwin, “Low volatility could make banks, hedge funds and other institutions more comfortable taking on extra leverage, paradoxically making the financial system less stable and more subject to large swings over time.” Soundmark’s Schultheis observed that we’re now experiencing the second-longest bull market on record. “There is a tendency for investors to become complacent and fearful. They may sell out of stocks even when minor corrections occur. Most recently this occurred during the market downturn at the start of 2016, and the subsequent sell-off when Britain voted to leave the European Union.” 

Opportunities for investors in a low-volatility climate

According to Schultheis, the current market climate of low volatility is an excellent time to review one’s financial plan, and specifically asset allocation between stocks and bonds for two reasons. “First, it provides a degree of comfort that one is financially able to weather the next market correction or bear market.  Second, it generates confidence that they are prepared to take advantage of a market downturn and to purchase (reallocate) from fixed income to stocks at an opportune time.” According to Schulthies, this is the opposite of what unfolds for most investors, as they sell stock positions throughout market declines due to heightened pessimism, fear and volatility attached to the VIX,” added Schultheis.

Gold believes now is an “incredible time” for investors to really take a look at where they are now, where they want to go and to determine if there are any gaps or obstacles that may be standing in their way. “When investors are not bombarded with headlines that the financial world is ending due to the apocalypse de jour, they have an opportunity to look at everything from a holistic standpoint and to be in even stronger financial position before the next storm inevitably comes.” Irwin, a renowned media pundit, believes the biggest risk of this period of ultralow volatility is that “by looking past the latest headlines out of world capitals, investors won’t send the signals that might prevent political leaders from making a mistake in the first place.”

However, as Schultheis cautioned, Soundmark tries to educate its clients about the importance of embracing market volatility and understanding that it is integral to the asset class that drives its premium return above riskless assets over time. Schultheis said many of his clients are aware of the extended nature of the current bull market and “voice their anxiousness” about the inevitable correction that comes with it.

Conclusion

“We remind clients that their current allocation between stocks and bonds reflects their ability to withstand market downturns.  These discussions are especially important for folks who are retired and drawing income from portfolios,”  said Schultheis. 

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TAGS: Kyle Walters, Atlas Wealth Advisors, Bill Schultheis, Soundmark Wealth Management, Michael Gold, Gertsein Fisher,VIX, market volatility