Maybe Strangely Low Stock Volatility Isn't So Strange After AllBy
Volatility is low. But does that mean it’s abnormal?
A group of researchers and economists at the Federal Reserve Bank of New York set out to answer that very question in a blog post Monday; the results weren’t so clear cut. “Are investors complacent? The evidence is mixed,” they wrote.
The Cboe VIX Index, which measures implied volatility of S&P 500 stocks, has ticked higher in recent days. But even with the gauge now sitting above its average level for 2017, it’s still far below the bull-market average.
“Based on similarities to the low-volatility environment before the financial crisis, some suggest that investor complacency may contribute to a major correction in equity markets when volatility returns to a ‘normal’ level,” the authors wrote. Should the VIX return to its average of around 20 since 1990, the S&P 500 could fall 5 to 10 percent, according to the authors.
But what if today’s seemingly abnormally low levels of volatility aren’t so abnormal, and that it’s the volatility of the past that was oddly high? To check the hypothesis, the authors looked to a theory of asset pricing -- the idea that stock prices are equal to the expected value of discounted dividends. Going by that, equity valuations and dividends should have roughly the same volatility.
That hasn’t been the case, though. Since the 1950s, stock prices have experienced nearly 10 percent more volatility than dividends -- a result, for the most part, of wavering investor sentiment, according to the authors who cite Robert Shiller’s research. Today, realized volatility is about 6 percent -- closer to the 7 percent historic volatility of dividends -- so maybe volatility that now seems freakishly low is actually where it was always supposed to be.
On the other hand, the authors found some evidence that volatility is being held down by traders selling options hand over fist, potentially a sign of complacency. They looked at the gap between realized and implied volatility in the S&P 500, treating it as a kind of profit margin for sellers of options. Right now, it’s less than half its historical average.
“Beyond the current level, we can also observe that the volatility risk premium has been below its long-run mean and has exhibited less volatility since around 2012,” they wrote, adding: “the volatility risk premium appears to be low both in absolute terms and relative to its historical norm, which may suggest complacency.”