Thursday, May 22, 2014

Volatility Is Now At Multi-Year Lows

One indicator that has remained consistently positive in our weekly summary table is volatility (Vix). Volatility has remained below 20 since the start of 2013, with the exception of about 5 days. This correlates with strong equity returns.

There's a tendency to believe that low, prolonged volatility is unusual. It isn't. This is the third multi-year period of low volatility in the past 20 years. Coincidentally, the prior two periods were also mid-decade, like the current period.

On the surface, therefore, there is no reason at present to expect volatility to make a sustained move above 20.

There are, however, reasons to expect volatility to move higher from here over the next several weeks.

Let's start with some perspective. Today, Jim Bianco noted that bond, currency and stock volatility are all at lows only seen once in the last 25 years: 2007. That was a significant low from which volatility moved substantially higher. Below is a one-month implied volatility chart from Nomura as an example.

Right now, one-month at-the-money Vix options volatility is around 35%. This is the lowest level since Vix options began trading in 2004.  According to Barrons, the prior low was in December 2013; Vix was 80% higher by the end of January.

Sentimentrader has also looked at one-month implied volatility. Of the 45 prior times in the past 8 years that this has been less than 45%, Vix was higher in the next 3 months 93% of the time by an average of 21%.

Vix is currently at 11.8. Since 2007, it has only been this low twice: March 13-15 and August 5, 2013. Both times, Vix was about 40% higher within the next month, and SPX moved lower.

Chad Gassaway looked at prior times since 1992 that Vix was below 13 and also more than 15% below its 50-dma, as it is now. In every instance, Vix was higher at some point within the next 3 weeks. 3-week gains in Vix averaged nearly 12%.

Moreover, last week, Chris Prybal showed that Vix call buying had spiked higher, something that marked prior lows in volatility.

There is a seasonal inclination for Vix to move higher in summer; The main exceptions have been in years when volatility was at a high level in the earlier part of the year (like in 2003 or 2009). The seasonality is not exact. In the past several years, spikes higher have come in May (2010, 2012), June (2013) and July (2011). Even in recent years, the moves higher have been more than 50% off the lows.

There's a tendency to think of the low volatility in the mid-90s and mid-00s as being homogenous. It wasn't. In both periods, lows under 12 alternated with highs in the upper teens. The cycles were generally less than 2 months (from low to high).

None of this is to suggest that we are at a 2007-like moment, or that Vix won't be lower in 2014. If the 1990s and 2000s are a guide, it will be. But history suggests that the risk/reward favors a much higher Vix over the next several weeks.