What's Up With the Tranquility in U.S. Stocks?

Source: Legion of Honor via Bloomberg

"Sleeping Dog" (1650) by Gerrit Dou. Close

"Sleeping Dog" (1650) by Gerrit Dou.

Source: Legion of Honor via Bloomberg

"Sleeping Dog" (1650) by Gerrit Dou.

March 28, 2013 - Since the middle of 2012, when fears of a euro zone breakup were squelched by European Central Bank Mario Draghi’s pledge to do “whatever it takes” to preserve the euro, U.S. and global stock markets have surged. At the same time, there has been a decline in stock market volatility: the VIX index, the so-called “fear index” measuring anticipated stock market volatility, is far below its historical average. So stocks are up and markets are calm. Will investors be rudely jolted from this serenity by a surge in volatility?

The VIX index may not be the best indicator of where stock-market volatility is headed. The index uses options prices to gauge expected volatility of the S&P 500 but only over the next 30 days. That's too short a time to incorporate all the potential catalysts for a spike in volatility, from a bank run in Cyprus to legislative gridlock in Washington.

Perhaps a better predictor is futures contracts on the VIX, which allow traders to bet on what the level the index will be at on specific dates in the future. The prices of VIX futures contracts do indeed suggest that volatility may rise. The index is now close to 13, but futures contracts expiring in December have a price close to 20, near the index’s long-term historical average of around 21.

This difference doesn’t suggest any massive surge in volatility. VIX futures prices tend to assume that over time the index will revert to the mean. So the anticipated increase isn’t unusual. And compared to recent history, the slope of the VIX futures curve is not particularly steep. By September 2012, for example, the VIX had plunged after Draghi’s comments and the announcement of the ECB’s program to support the bonds of struggling European governments. Yet prices for 9-month VIX futures were above 25, at a time when the VIX index was below 15.

The mild upward slope of the current VIX futures curve suggests that traders are anticipating only a slight increase in stock market volatility. Despite the potential of the global economy to throw markets into disarray, they expect the current tranquility to last for a while longer.

Adam Freedman is an investment strategist with BloombergBlack, a personal wealth management system.

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