Friday, June 16, 2023
- Evidence of a regime shift from high to low implied volatility is building. The CBOE Volatility Index—or more commonly referred to as the VIX or ‘fear gauge’—has recently dropped to multi-year lows after spending most of last year at above-average levels.
- Historically, periods of high volatility have been followed by periods of low volatility, especially during the transition from a bear to a bull market.
- The term structure of the VIX futures curve has reverted back to its normal upward-sloping shape, adding to the evidence of a shift toward a low-volatility market environment.
- What does this mean for market returns? While high implied volatility has historically produced the highest average S&P 500 returns, the standard deviation around these returns is also relatively high. Periods of low volatility have historically generated above-average returns with less dispersion.
While the S&P 500 recently entered a new bull market by climbing 20% above its October 12 low, the same bear market continues for implied equity market volatility. The VIX has been trending lower since January 2022 and recently fell to its lowest level in over three years. For context, the VIX represents implied volatility derived from the aggregate values of a weighted basket of S&P 500 puts and calls over a range of strike prices. Generally, a rising VIX is associated with increased fear in the marketplace and falling stock prices, while a declining VIX is associated with decreased investor fear and rising stock prices. In addition to speculative positioning, the VIX is used as a sentiment gauge and to hedge positions.
Stocks Breaking Out, Volatility Breaking Down
Given the current trend and level of the VIX, many investors are now asking if low volatility is here to stay. The VIX futures can help answer that question. As shown below, the term structure of VIX futures has shifted considerably over the last year. The orange line represents the VIX curve on June 16, 2022, while the dark blue line represents the VIX curve as of the October 12, 2022 market low. During these periods, both curves are in “backwardation,” meaning they slope downward as shorter-term contracts are more expensive than longer-term contracts. This is generally the result of elevated market uncertainty driving up short-term hedging costs from a volatility standpoint. Historically, backwardation is short-lived and often found near major market bottoms including during the throes of the Global Financial Crisis in November 2008, the U.S. credit downgrade in 2011, the near-bear market drop in late 2018, and during the pandemic of 2020.
The current VIX futures curve is upward sloping or what is also called “contango,” which is the opposite of backwardation as longer-term contracts are more expensive than shorter-term contracts. The VIX is usually in contango during a normal, low-volatility environment (80% of the time, according to the CBOE). The higher cost associated with longer-term VIX futures results from an embedded time premium investors pay for hedging against potential future risk. Generally, there is a higher chance of market risk developing over a longer time frame compared to a shorter time frame, hence the higher cost going out on the curve (i.e., a higher chance of stocks dropping 5% over a one-year period vs. a one-week period).
While the shape of the VIX curve can change quickly, the change in term structure from last year’s bear market backwardation curve to the current contango curve adds to the evidence of a regime shift to lower volatility.
What Does Low Volatility Mean for Stock Returns?
Lower volatility doesn’t always equate to above-average equity returns, as market bottoms are often accompanied by periods of high volatility. The table below breaks down the VIX into quintiles based on closing prices going back to 1990. The first quintile represents trading days with the highest implied volatility, or the top 20% of all VIX closes. In contrast, the bottom quintile represents trading days with the lowest implied volatility, or the bottom 20% of all VIX closes. Forward S&P 500 returns for each VIX quintile group are also shown, along with the standard deviations of each return period.
The first quintile group, representing the highest periods of implied volatility, has historically produced the highest average S&P 500 returns. However, the returns in the first quintile group also come with a wide dispersion, evidenced by the standard deviation of returns being around double that of the fourth and fifth quintile groups. Furthermore, the fourth (where the VIX is currently trading) and fifth VIX quintile groups have still generated above-average S&P 500 returns with less variance.
Evidence of a regime shift from high to low implied volatility is building. The VIX has recently dropped to a multi-year low of 14.5 as of June 15, placing it in the fourth quintile group after spending most of last year at above-average levels. Historically periods of high volatility are followed by periods of low volatility, especially during the transition from a bear to a bull market. The term structure of the VIX futures curve has reverted back to its normal contango shape as hedging demand for near-term risk has dissipated. While high implied volatility has historically produced the highest average S&P 500 returns, the standard deviation around these returns is also relatively high. Periods of low volatility have historically generated above-average returns with less dispersion.
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