There is no volatility paradox

Most have used charts like this:

Last Summer I wrote about how the Vix is not a good measure of complacency (not a new argument) and last month I tackled similar issues with regards to dispersion. Chris Dillow has written the best piece on why the current situation does not represent a paradox (including the issues with the metrics used) and importantly touches on the nature of what drives asset prices.

Dillow notes that low volatility emerges in a situation when there is a relatively symmetrical distribution between those who think prices should be higher and those who think they should be lower. Those who are looking to sell can relatively easily find buyers at close to the prevailing price. If the environment is “uncertain” there is no reason why beliefs shouldn’t be relatively evenly distributed, in fact you may expect this to be the case.

This is a good explanation for why markets may be relatively more static than usual on a day to day basis. But the S&P has not been static overall, it has risen sharply.

The inverse relationship between the direction of the S&P 500 and the VIX index is well documented, so perhaps the real question being asked is not why the VIX is low, but why the S&P trended higher.

For this to happen there needs to be a more asymmetric shift in beliefs, with a greater number of investors willing to buy at a higher price. We have argued that this is in part due to the removal of pessimism that existed early last year. Part of the policy uncertainty that now exists includes the possibility of a US or global ‘reflation,’ which, even if not the base case for many, didn’t even seem to be part of the probability distribution a year ago.

There is another reason why uncertainty can be associated with trending behaviour. In truly uncertain conditions the sense of a ‘valuation anchor’ is loosened. Valuation anchors provide us with a sense of whether an asset is ‘cheap’ or ‘expensive.’ If everyone was convinced that the historic mean of the Shiller price-to-earnings ratio was a useful measure, then the price of stocks would never differ too much from it.

However, markets periodically give up on these anchors. In the case of the tech bubble, the belief that we were moving to a new world of higher growth (justifying structurally higher valuations) proved to be overdone. In the case of developed market government bond yields, a belief that we have moved to a world of permanently lower real interest rates has so far been vindicated.

In such cases, uncertainty about what level of an asset price is cheap or expensive can lead to overshoot and trending. If investors are less clear what level is cheap or expensive, they are less likely to bet on some sense of mean reversion. This idea has been used to explain why overshoots take place in assets with less clear valuation anchors, such as currencies or commodities (see for example on page 11 here).

Given the importance of interest rates and inflation to equity valuations it is perhaps no surprise that ideas of what is cheap and what is expensive may be softened. Much commentary reveals deep uncertainty about the structure of the economic regime: Are rates going to stay lower forever? Are we seeing a pronounced challenge to prevailing economic ideology? How relevant is the link between interest rates and growth?

Recent trending behaviour in the S&P 500 can be seen in the behaviour of the momentum index.

Low volatility and trending behaviour can be entirely consistent with a world of heightened uncertainty about the prevailing regime. The question for investors is whether valuations look attractive in their own right.

However, the very fact that so many investors and commentators are searching for signs of complacency should, if anything, provide comfort that bubble-like euphoria is not dominating the landscape today.