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Volatility can be a good indicator of the maturity of a stock market rally or break. Volatility tends to decline when the stock market is rising and rise when the stock market is falling, and has a tendency to mean revert over time – trade in a sideways trend. As a result, extremes in volatility can be an indicator of when the stock market is becoming overbought or oversold. It is a useful tool in a market timing tool kit.
The macro drivers of volatility:
The macro drivers of volatility relate to economic growth (earnings) and some combination of interest rates, monetary policy, and credit conditions. Holding other factors constant, volatility tends to fall when earnings growth is positive and strong, and tends to rise when earnings growth is weak or contracting. A prime example of the relationship would be a surge in volatility during the financial crisis and economic contraction in 2008.
Volatility tends to compress when interest rates are low and rise when interest rates are increasing. In fact, there is about a 2 year lag between the federal funds rate and the level of the VIX. Similarly, an expansion in credit spreads or credit risk will cause volatility to rise, while a narrowing of credit spreads or credit risk will cause volatility to fall. A review of the EZ debt crisis provides an illustration. The Greek debt crisis occurred about May 2010 and Portugal and Italy generated credit fears in the summer of 2011. In both these periods the VIX rose sharply.
The micro drivers of volatility:
If you want to think about volatility in terms of a company, then think about a company with equity and debt in its capital structure. If its earnings fall, it becomes harder for the company to pay off or service the debt, so the risk of holding debt rises. This process follows through to the stock price. If the company cannot service or pay off the debt and defaults, then the equity could become worthless. In effect, the debt holders are in front of the equity holders on the capital structure and will own the company on default making equity worthless. Likewise, if a company cannot fund itself because of high interest rates or lack of access to credit, the equity could become worthless. The uncertainty over earnings, interest rates, and credit can generate equity volatility as default risk is priced.
How do I use volatility?
Volatility is in my tool kit of market timing devises. Since volatility tends to mean revert, low (high) volatility levels can signal the market is ripe for selling (buying). Volatility can be combined with sentiment indicators, option market indicators, and chart patterns to confirm and/or predict market extremes. I would not use volatility by itself, but that does not mean it is not useful.
Where are we today?
Volatility has been relatively tame over the last year, as the Fed has provided dramatic liquidity via its QE operation, European credit stress has been calm, and the global economy has expanded, albeit at a slow rate. Recession risks look limited in the near term and thus volatility is unlikely to find a dramatic upward increase from the growth picture, although a hard landing in China presents a risk to this view. Bigger picture a tapering of QE by the Fed could change the liquidity and interest rate backdrop. This may cause an increase in volatility. The fed funds rate is likely to be low, but the recent rise in treasury yields on QE taper talk highlights the potential impact of reduced QE on the capital markets. A tapering Fed could lift volatility.
The number of S&P 500 stocks over the 50 day moving average is over 80%. This is an elevated reading, but not extreme. The percentage suggests the recent rally is maturing, and investors should be mindful of risk. The February and May/June 2013 corrections saw percentages over 90%, so there is some cushion. Likewise, the 10 day average of the CBOE put to call ratio is 0.89. It will hit the lower end of its range, suggesting heighted risk of a sell off, when its works below 0.85.
What does volatility say about the current rally?
Since 2010, 30 day historical volatility on the S&P 500 has struggled to maintain levels below 8.5%. Volatility has spent less than 5.0% of the time under this level since 2010. As a result, declines in 30 day volatility under 8.5% should be viewed as a sign the market is becoming vulnerable to a correction. At writing, with Friday’s calm session, 30 day historical volatility was 8.7% and starting to hit unusually low levels. The dip is worth noting and monitoring. As the graphic shows, this dip does not mean the market is going to run out of gas, but it is worth watching.
A summer lull in trading activity could also pressure volatility, as the vacation season may cause option traders to pay less for volatility. Seasonal factors can play a role in volatility pricing and this could be a factor in August. Low volatility in August is probably less troubling than low volatility in September, holding other factors the same.
The 1700 area is important psychological resistance for the S&P 500 and lack of a clean punch higher could spark some selling if longs get tired. However, the fundament story seems intact for continued stock strength given on going Fed QE, signs of improved economic growth via PMI figures, and the ability to discount the Q2 earnings season.
The VIX was trading just above 12.0 at writing and closing in on the lower end of its one year trading range. The low in March 2013 was 11.3. Volatility can range at low levels for a relatively long period, but note the current reading in the context of history. The last time the VIX was this persistently depressed was during the mid-2000’s when there was a rough range between 10 and 20.
Don’t ignore volatility at current low levels. It is worth watching and should be part of your market timing tool kit. Low volatility in September could make for a rough fall.