Low volatility could be a bull's best friend.
Technical strategist Chris Verrone of Strategas Research Partners joined us this morning on Surveillance to dispel the notion low volatility implies complacency and a pending correction.
Currently, the Chicago Board Option Exchange Volatility Index (VIX) sits near an eight-year low. Since volatility is the single most important determinant of option pricing in the widely used Black-Scholes model, traders apparently have a low expectation that stocks will change direction abruptly in the near future. In other words, there's very little fear priced into the market.
Should we be concerned that the pros are too complacent?
Mr. Verrone says no. He cites two extended periods of exceptionally low volatility during the past 20 years, and notes the current downshift is in its early stages.
More importantly, low volatility is good for stocks. Adding the S&P 500 Index to the VIX chart, we observe that stocks rallied considerably during these two low volatility periods. No fear, no problem.
As for how long this "Goldilocks" scenario might play out (and thank you, Chair Yellen, for continued support via low rates), Mr. Verrone says the current rally is about average in length. The S&P 500 Index has remained above its 200-day moving average for 402 days. The longest such run occurred in 1953 -1954 and lasted 627 days; the shortest lasted 355 days in 1958.
A closer look at the current rally reveals seven pullbacks along a very consistent uptrend. Volatility has fallen simply because the rally has been so orderly.
Should we be afraid? We think not.
--Morgan Stanley strategist Adam Parker forecasts earnings growth of 7 percent.
--Citigroup Inc. strategist Tobias Levkovich cites a price-to-earnings valuation at the midpoint of the historical range of 14 to 17.
--Yellen & Co. continue to pledge low rates for a "considerable time."
Until these fundamentals change, pullbacks are opportunities to add to winners. Be smart, but don't be afraid.
Happy July 4th. We return next Monday.