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05/07/2017

CIO Blog: The only thing to fear is fear itself

Imagine you have just climbed onto a rollercoaster, the bar has lowered overhead and locked you in.

Imagine you have just climbed onto a rollercoaster, the bar has lowered overhead and locked you in. Now the carriage is moving upwards, slowly clicking as it rises, creeping to its apex. Legs dangling, you brace for a steep fall…and whoooooosh!! That is what it can feel like for investors when volatility levels are high. At present, it is more like the tranquil turn of the toddler-teacups: with volatility so low, it can only go in one direction. Should we worry?

Using history to reduce the mystery

The most common measure of volatility is the CBOE’s Volatility Index, more commonly referred to as the VIX index, or simply the VIX. It measures activity in the derivatives market around the bellwether S&P 500 stock index. To make a long mathematical calculation short, it shows how far investors are betting the S&P 500 will be from its current level in one month. If more activity than usual is taking place in the options market with many betting on large gains or steep falls – or both – the VIX goes up. If investors are placid, with little conviction on changes from the present level, then VIX is low. At current levels, investors are in deep-tissue massage territory.

History remains, ironically, the best place to be guided about the future. Unfortunately, with the VIX index, we don’t have a lot of it; the index itself was only created in 1990. However, using the historic 60-day volatility – which is highly correlated – we can extend our analysis to 1953. We can draw several important conclusions from this empirical examination.

First, just because volatility is currently low, there is no reason to expect a spike, or even for it to trend higher. Volatility is more likely to remain in the same quintile over a 12 month timeframe. This is evidence of volatility “clustering” – the idea that volatility tends to stay at the same level for a while – until such  (unpredictable) time when something causes a new volatility regime. This can be thought of a striker in football being more likely to score a goal in a match after he or she has already scored one. When you’re hot, you’re hot. Similarly, when the striker is in a lean patch, the chances of scoring in the next game lessen too.

Second, what equity investors are really interested in is if any inference about future returns can be drawn from volatility levels today. It would be intuitive to suggest returns from low volatility regimes, such as now, would be lower than those from higher volatility starting points; after all, things can only get “worse” – less calm – from these historical lows. While we find some evidence to suggest forward equity returns are slightly constrained from lower volatility starting points, we draw another important conclusion: lower volatility starting points are not, on average, indicative of forward equity market losses. The long-term upward bias of the equity market is strong and it would be foolhardy to use low volatility alone as a market-timing tool to reduce equity exposure.

Third, inevitably, some trigger event will kick off a shift in volatility from current low levels to higher levels. This eventuality, an inevitability, should not cause alarm on its own. We find in times when volatility is high, equity markets tend to have slightly more attractive subsequent return characteristics than, on average. Surely, Warren Buffet’s old adage comes to mind: ‘be greedy when others are fearful’. Indeed, perhaps they don’t need to be too ‘fearful when others are greedy’!

Investment implications

The reality is investors currently are somewhat crowded in equities, with little conviction on asset classes elsewhere. There are no great expectations for high returns or for a sharp drop, thus volatility – the future volatility implied by options market prices – is low. But even if volatility were high, we would take it with a pinch of salt for all the reasons described above; simply put, there is no empirical case to make asset allocation shifts due to volatility alone. We will not, to quote former US President Franklin D. Roosevelt, “fear ‘fear’ itself”.

At present, while we recognise a low-return backdrop to global markets, we remain mildly sanguine. Equities are not overvalued across a number of measures (for example price-to-book ratio). Moreover, the asset class continues to be supported by strong momentum. While volatility is low, few would describe the mood amongst investors as complacent. If anything, this long-running bull-market has been characterised by caution and some key sentiment indicators are displaying “oversold” characteristics. Therefore, equities are still our most significant allocation across balanced portfolios, though our stance is best described as neutral. Within the asset class, we prefer regions where there is better value, such as the Eurozone.

We also recognise that markets can move with staggering speed and we continue to have significant allocations to government and investment grade bonds in spite of record low yields and high valuations. They are held primarily to diversify away from equity risk. But that is not the only reason. Fixed income securities are also in positive momentum and surrounded by negative sentiment, both aspects we like. It is prudent to remember that they have delivered excellent returns over the last three and five-year periods through conditions similar to today – a surprise to many. It is more than possible that they will continue to surprise on the upside, as they have done throughout 2017 thus far.

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