Donald Trump’s political travails injected some volatility into stock markets recently but 2017 has largely been a very quiet year. Prior to the Trump-induced nervousness, investors were more relaxed about the stock market than they had been for almost a quarter of a century, according to Wall Street’s fear index.
Many strategists argue any falls will be fleeting. The "overwhelming market narrative" equates to "don't worry, be happy", Convergex strategist Nicholas Colas argued recently. Should investors be worried by the lack of worry?
Historically low levels of anxiety have confounded those who assumed an upsurge in volatility was a given in 2017, what with the US Federal Reserve hiking interest rates and the White House being occupied by a president who has lived up to his reputation for erratic behaviour. Instead, the aforementioned fear index, the Vix, recently fell below 10 for the first time since early 2007. Less than half its long-term average, the Vix came within a whisker of 1993's all-time low.
The Vix is just one indicator and an imperfect one at that, but it's not the only evidence that markets have been oddly calm. Europe's equivalent, the Vstoxx, has been similarly low. Volatility is below historical norms in all of the major developed currency markets, according to Deutsche Bank. Expectations regarding future volatility are "at or near one-year lows across every asset class and nearly every region", Credit Suisse noted recently.
For traders, the lack of action has been hard to bear. “Life in front of a screen becomes one big ironic Kafka novel,” complained London-based Acumen Management in a recent note. “Ultimately, you might have a view and it might even be the correct one, but waiting for it to play out and/or move in any decisive way is simply torturous. Not to mention the loss of the will to live, self-belief and perpetual self-examination.”
Ordinary investors, on the other hand, are unlikely to complain. Stocks have quietly risen, with the MSCI World Index hitting all-time highs, and there have been precious few of the sharp pullbacks and drawdowns that can prove unnerving in more normal market environments.
However, many observers are concerned. Volatility gauges like the Vix rise when investors buy insurance to guard against potential declines. A low Vix suggests investors don't envisage any obstacles ahead, which could be seen as complacency. Stock market volatility is "insanely low", according to influential bond manager Jeffrey Gundlach.
He may be talking his book – bond managers tend to play up the risks of owning stocks – but former Federal Reserve governor Kevin Warsh, often talked of as a future successor to Fed chief Janet Yellen, recently echoed Gundlach's concerns. Asset prices are not prepared for downside shocks, said Warsh, who cautioned the current uniformity of opinion in the marketplace was reminiscent of that seen 10 years ago, prior to the outbreak of the global financial crisis.
"I would not take comfort" from the low levels of volatility, said Warsh. "I would take fear." Former Fed chairman Ben Bernanke has also described the low volatility as "a little puzzling" as there are "plenty of risks in the world".
If market calm is genuinely indicative of market complacency, then asset prices may be more vulnerable than they appear. Additionally, there is always a danger that quiet markets will encourage traders to take on excessive risk, such as using leverage to juice returns.
Investors have arguably become conditioned to see every minor market dip as an automatic opportunity; why worry about market disruptions when central banks are always ready to run to the rescue? Although rates may be gradually rising in the US, global monetary policy remains stimulative. This is especially true of the Bank of Japan, which hoovers up Japanese equities on down days and which is now the world's biggest exchange-traded funds (ETFs) investor.
However, a quiet market is not necessarily a complacent market. Low volatility need not imply investor euphoria, says Japanese securities firm Nomura. Rather, indecision may be dictating stock market movements, with uncertainty regarding the Trump administration's policies resulting in "cautious investor positioning and even inactivity".
This inactivity has been especially marked in the US. In one particularly dry recent spell, the S&P 500 moved by less than 0.2 per cent in 10 out of 11 days. Only once over the last 90 years have traders witnessed such a persistent lack of movement, according to Deutsche Bank data. LPL Research notes that there have been only three days this year where the S&P 500 moved up or down by at least 1 per cent, the smallest number since 1972.
“Some of the best years in market history have also been among the least volatile”, the firm notes, arguing investors should not make the mistake of assuming that this is a case of the calm before the storm. That was the case in 2007, the last period that witnessed a market environment as quiet as the current one, but the low Vix readings of 1993-1994 were followed by five years of big market gains.
Still, long-term returns tend to be substandard following periods of very low volatility, says Deutsche Bank's Jim Reid.
According to Reid, returns have historically been poorer following periods of very low volatility. This is not always the case – “ultra-low” volatility “doesn’t necessarily predict bad returns going forward”, says Reid – but returns are generally higher when volatility is higher than it is today.
The likely explanation, he says, is that low volatility tends to be associated with confident markets where stocks are “priced for perfection”.
Another possibility is that the current quiet is neither bullish nor bearish but merely reflective of structural and permanent changes in financial markets. The notion that today's markets are too quiet rests on the assumption that past levels of volatility were both normal and correct. As far back as 1980, however, Nobel economist Robert Shiller famously argued that stock prices move too much to be justified by subsequent changes in dividends. Far from being perfectly efficient, Shiller posited that stock markets were far more volatile than they should be.
Today’s markets are very different. Individual investors are now bit players, with stocks largely driven by algorithms rather than emotions. Markets are more efficient than they were in the past and arguably less prone to panics. Accordingly, might it be the case that markets were too jumpy in the past and that we have now entered a new era of permanently lower volatility, where stocks only move sharply higher or lower when they have a specific fundamental reason for doing so? Markets may have “wised up” in this respect, as Ben Bernanke put it recently.
In truth, no one knows for sure, although Deutsche Bank doesn’t subscribe to that thesis, saying market quiet will not last forever. Policy risks are under-priced, the firm says, adding that a “turning point” is “close”.
The belated market response to Donald Trump’s recent difficulties would seem to bear out Deutsche Bank’s caution. Volatility has been dormant, but it’s not dead just yet.