Volatility Falls to Seven-Year Low as S&P 500 Rallies

Traders Work in the Volatility Index Options Pit at CBOE
The Chicago Board Options Exchange Volatility Index slid 8.3 percent since June 28, a retreat that coincided with a 5.3 percent advance in the S&P 500 and a 39 percent windfall for investors who used an exchange-traded note that bets against equity swings. Photographer: Tim Boyle/Bloomberg

For all the concern that the Federal Reserve may reduce economic stimulus and the stalemate over the U.S. budget could lead to a government shutdown, stock investors are the calmest in more than seven years.

The average daily change for the Standard & Poor’s 500 Index narrowed to 0.45 percent in the third quarter, the smallest since the end of 2006, data compiled by Bloomberg show. The Chicago Board Options Exchange Volatility Index slid 8.3 percent since June 28, a retreat that coincided with a 5.3 percent advance in the S&P 500 and a 39 percent windfall for investors who used an exchange-traded note that bets against equity swings.

U.S. stock fluctuations are narrowing as investors become more confident that the four-year bull market is sustainable, corporate profits top all-time highs and growth in China and Europe show signs of strengthening. The Fed this month refrained from slowing its monthly bond buying, saying it needs more evidence of an improvement in the American labor market.

“Toward the end of August everyone was geared up for the first tapering from the Fed and a market sell-off, but it didn’t happen,” Justin Golden, a partner at Lake Hill Capital Management LLC, said via phone on Sept. 27. The New York-based hedge fund trades options on equity indexes and commodities. “People think the markets are pretty smooth sailing for the next few months.”

Quarterly Gain

U.S. stocks have rallied this year, putting the S&P 500 on track for a third straight quarterly advance. Strategists from Barclays Plc, Citigroup Inc. and Bank of Montreal raised their year-end forecast for the U.S. equity benchmark in September on speculation that the Fed will trim bond purchases at a slower pace than previously anticipated.

The VIX, a measure of the cost to protect against declines in the S&P 500, is on pace for its second consecutive annual decline after tumbling 14 percent in 2013. It closed at 15.46 on Sept. 27, 24 percent below its average since 1990.

Federal Reserve Bank of Chicago President Charles Evans, who has been among the central bank’s most vocal proponents of record stimulus, said last week more signs of strength in the economy are needed to reduce asset purchases. The Fed has left its main interest rate near zero since December 2008 and has expanded its balance sheet to a record $3.66 trillion through three rounds of stimulus to induce economic growth.

Price Swings

Price swings in the S&P 500 reached their highest ever in the fourth quarter of 2008, when daily moves averaged 3.31 percent during the height of the financial crisis, according to data since 1929 compiled by Bloomberg. Volatility was lowest in 40 years at the beginning of 1995, when the S&P 500 posted an annual gain of 34 percent, one of the five best years on record.

The VVIX Index, a measure of VIX swings, slipped 13 percent to 74.93 in the quarter through Sept. 27, the biggest retreat since 2010. The gauge in August reached its lowest level in almost four years, a sign that investors are less concerned about future stocks swings.

“The price of VIX options is just abnormally low compared to earlier this year and where we were in 2012,” Lake Hill’s Golden said. “Everyone was setting up for an event, it never happened, people were surprised and now you see the lack of fear by virtue of these prices on VIX options.”

Inverse VIX

Investors who wagered that volatility would decline profited in the third quarter. The VelocityShares Daily Inverse VIX Short-Term ETN jumped $7.82 to $27.80 since June 28 for the ninth-highest return among exchange-traded funds in America through Sept. 26.

The security, which rises when the VIX falls, reached a record $29.10 on Sept. 19. While the fund has a market value of about $308 million, it is the 17th-most active exchange-traded fund in the U.S., according to data on more than 1,500 funds compiled by Bloomberg.

The ProShares Short VIX Short-Term Futures, which also earns the inverse return of short-term futures on the U.S. volatility gauge, rallied 39 percent in the quarter through Sept. 27.

Weakness in economic growth and political wrangling over the country’s fiscal policy may reignite volatility, according to Matthew McCormick of Bahl & Gaynor Inc. The U.S. Senate voted last week to finance the government through Nov. 15 after removing language to choke off funding for the health care law, putting pressure on the House to avoid a federal shutdown set to start Oct. 1.

Tired Trade

“The low volatility trade is tired and there are a lot of potential catalysts out there, including what’s going on in Washington,” McCormick, a Cincinnati-based fund manager at Bahl & Gaynor where he helps oversee in $9.6 billion of assets, said by phone on Sept. 24. “The Fed’s non-action has caused investors to reevaluate their view on the economy, which is not doing as well as people thought.”

U.S. stocks fell last week amid concern a political impasse in Washington will hurt the economy. Hardening positions on the federal budget and borrowing limit, and political setbacks by both President Barack Obama and Republican congressional leaders as they go into the fight, are raising the odds of a government shutdown, debt default or near-miss that could roil equities markets.

Forty percent of global investors surveyed in a Sept. 10 Bloomberg poll said they would pull back on U.S. markets in the event of a government shutdown. The VIX advanced 7.4 percent to 16.60 today, the highest since Sept. 3. Its counterpart in Europe, the VStoxx Index, gained 15 percent to 19.45 for its biggest advance in a month.

Uncertainty, Boredom

A reduction in stock trading helped subdue volatility in the third quarter, according to Michael Schmanske of New York-based Glenshaw Capital Management LLC. Volume for U.S. exchange-traded equities averaged 5.7 billion shares a day this quarter, the lowest since Bloomberg data begins in 2008. That represents a 13 percent drop from the second quarter and compares with the 7.77 billion quarterly average since the bull market began in 2009.

“It seemed market participants were plagued by uncertainty, boredom and general lack of interest in equities,” Schmanske, founder and chief executive officer of Glenshaw Capital Management, said in an interview on Sept. 26. “This summer, investors mostly stayed on the sidelines.”

The cost of bearish S&P 500 options has dropped since the June high, relative to bullish contracts. Puts protecting against a 10 percent decline in the index cost 8.48 points more than calls betting on a 10 percent rally, according to three-month data compiled by Bloomberg. That’s down from a one-year high of 10.93 on June 20 for the price relationship known as skew, the data show.

‘Rolled On’

Traders own more options betting on lower volatility levels than higher. Among the 10 most-owned contracts on the iPath S&P 500 VIX Short-Term Futures ETN, eight were wagering on reduced swings, data compiled by Bloomberg show. January $10 puts, with an exercise price 30 percent below the last close, and November $13 puts had the largest open interest.

“There were a lot of things on the calendar that could have made the quarter volatile, but as the months rolled on and the news rolled in, the storms clouds on the horizon started to fade,” Brian Jacobsen, who helps oversee $221.2 billion as chief portfolio strategist at Wells Fargo Advantage Funds in Menomonee Falls, Wisconsin, said by phone on Sept. 26. “We can see movements on the margins in the VIX, but I really don’t see a lot that’s going to push it up into the 20s.”

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