By now, I am quite sure, you have tired of the stories on the “The Fear Index,” how the CBOE Volatility Index1 (VIX) is making a historical low and how we all are doomed because…well…haven’t you heard that the VIX is making a new low? (See Exhibit 1.)
I don’t get the hullabaloo about the VIX, though. In an environment where global growth is relatively stable, policy makers go out of their way to tell us how and what they are going to do, credit spreads are making new lows, and global equities have been on a tear for more than a year, what else would you expect from the VIX?
VIX: A Lagging, Not Leading Indicator
In other words, we believe the VIX is a lagging rather than a leading indicator. It is a reactive market factor rather than a proactive market factor. As a result, making too many portfolio decisions based on the potential catastrophes that a new low in the VIX could likely engender is just silly.
That is not to say that volatility is unlikely to increase. It may, or it may not, for a while. But it wouldn’t be because the VIX itself made a new low and somehow reflects that investors have been bad and irresponsible. Far from it.
The proof in the pudding for complacency is investor flows. If investors have been acting in a cavalier manner (and as investors we know we do that at times), it would be reflected in the flows into various types of funds. But that has not been the case. There have been no en masse flows into any asset class. Yes, investors have been moving into emerging markets and European equities, and they have been reducing their exposure to the United States. And, on the basis of the fundamentals of economic and political reality on the ground, you would expect them to do that.
If there have been pronounced flows since the beginning of the year, they have been in bonds rather than risky equities. And as we all can agree, no one is buying bonds at current levels to get rich quickly.
The bottom line is that if you are trying to foretell potential disasters in the market, look at fundamentals and asset class flows. Watching the VIX is not going to help.
As is always the case in the markets, we face significant fundamentals-driven risks that we need to watch out for:
- China’s policy-induced slowdown may prove to be a disaster,
- The U.S. may slow down more than expected,
- Inflation may pick up, forcing the Federal Reserve to tighten more than what we are expecting today, and
- Some election in Europe may shape up to be the next (fill-in-the-appropriate-country initials) exit.
So, there is a lot to fret about. But the VIX making new lows, somehow, is not at the top of my worries. I will let my options and derivatives brethren worry about that.
I remain focused on the global economy, monetary policy and company fundamentals. While it is risky as always, those fundamentals look quite decent.
1The CBOE (Chicago Board Options Exchange) Market Volatility Index or “VIX” is an index designed to measure the volatility of the S&P 500 Index by illustrating the market’s expectation of 30-day volatility via the options market. The index is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any particular investment.