Sometimes calmness to an extreme can seem downright eerie, and for investors, 2017 was one of those times.
The VIX volatility index, often referred to as Wall Street’s fear gauge, hovered near record lows for much of the year. The index measures how much volatility investors can expect to see in the Standard & Poor’s 500 index over the next 30 days, based on forward-looking options prices.
Large stock market gains (the S&P 500 has gained about 19 percent over the last 12 months), coupled with low volatility has raised concerns that perhaps investors are a bit too calm — complacent even — and as a result, are probably unprepared should the market take a downward turn in 2018. When the VIX fell below 10 percent in May, and then continued to trade near record lows since then, some commentators were quick to draw a comparison to the last time investors felt this at ease.
It was during the housing boom just before the onset of the Great Recession.
[See: 7 of the Best Stocks to Buy for 2018.]
“Many people are having a difficult time reconciling the strength in risk assets with the drama playing out in Washington and on the global stage, so it is reasonable to wonder whether investors are becoming complacent,” says Adam Phillips, director of portfolio strategy for EP Wealth Advisors in Torrance, California.
Even Federal Reserve officials have expressed those fears. Minutes from the central banks’ policymaking meeting a month ago said, “In light of elevated asset valuations and low financial market volatility, several participants expressed concerns about a potential buildup of financial imbalances. They worried that a sharp reversal in asset prices could have damaging effects on the economy.”
So does a low VIX mean investors should, in fact, brace for higher volatility in the future?
In a blog post, researchers at the Federal Reserve Bank of New York call it a “puzzle” and say they have found mixed evidence that investors are overly complacent. On one hand, the VIX hovered around 9 to 10 percent for much of the year, well below its historical average around 20 percent since 1990. If the VIX were to revert to its mean, the S&P 500 would be expected to decline by 5 to 10 percent.
But on the other hand, “it is difficult to pinpoint the horizon over which the VIX may increase,” the researchers, David Lucca, Daniel Roberts and Peter Van Tassel, say. “An increase in the VIX from 10 percent to 20 percent has different implications if the move happens over one week versus one year.”
Plus, it’s unclear if the historical mean is the right benchmark in the first place. “If the post-crisis regime is different, the ‘correct’ level for the VIX may have changed,” they say.
[See: 7 Ways to Trade Volatility With ETFs and ETNs.]
The researchers also went on to find that low volatility today predicts slightly higher, but still low volatility not only one month into the future, but also 12 months from now.
Randy Frederick, vice president of trading and derivatives at the Schwab Center for Financial Research, also cautions investors not to read too much into the recent lows in volatility.
“A low VIX reading has provided an accurate signal of a short- or long-term pullback only once in the past 25 years,” he says in a research note. “Of course, it could happen again, but it’s more likely to be coincidence than correlation.”
In the end, it’s best to focus on the fundamentals and make sure your portfolio is diversified, Frederick says.
“You can’t control the markets but you can try to control the overall health of your portfolio,” he says.
It’s also important not to overreact when volatility eventually does return to the market.
“My fear is that we have been without real volatility for so long now that the next 5 percent decline could feel more like a 10 percent drop,” Phillips says. “We are using this opportunity to remind our clients that volatility is a normal part of investing and they shouldn’t be surprised or concerned when it reappears.”
For now, most of his clients are enjoying the market’s strong performance, but are mindful not to get too comfortable, he says.
[See: 7 Consumer ETFs for the Holiday Rush.]
“It’s like they are whistling in the dark — trying to exude a sense of calm but anxious about what might be waiting for them around the next corner,” Phillips says.
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Are Investors Too Complacent? originally appeared on usnews.com
