Colas - Reflections on the subdued state of the VIX

Nick Colas - ConvergEX
April 30, 3012

Remember the bright red convertible driven by John Travolta’s character in the movie Pulp Fiction?  It’s the one he used for his date with the boss’s wife, which started with dinner and dancing but ended with syringe to the heart.  Well, that car was actually Quentin Tarantino’s personal daily driver, and it was stolen during the making of the movie.  After 19 years on the run, police finally found it two weeks ago.  And Quentin will get it back.  “And you will know my name is the Lord when I lay my vengeance upon thee.”

I can’t but feel a little jealous that even Quentin’s cars – let alone the writer/director/producer himself – lead a more exciting life than I do.  Who knows what has happened to that red Chevelle, or in it, or around it, over the last 2 decades?   Let alone that Uma and John created their own little bit of movie magic riding around LA in the car.  And let’s not even discuss how Tarantino will celebrate its return.

At the other end of the excitement spectrum, we have the sleepwalking U.S. equity markets and an equally somnambulant CBOE VIX index plodding along in its footsteps.  The drip-drip-drip move higher for domestic stocks certainly fits the bill for a low volatility environment.  The old saw that markets take the stairs up and the elevator down has never been truer than now.  And this market feels like it is an old man walking up those stairs, arthritic knees and all.

Since the VIX is a short-term measure of expected volatility – 30 days  - it should be no surprise that it hews closely to the actual volatility of stocks over the last month.  At the same time, a 13.X VIX reading is unusually low for this indicator.  The long run average is 20, and it strains credulity to think that current macro conditions are less volatile than the last three decades.  Just consider that the VIX hasn’t closed above 20 at any point in 2013.

The common wisdom for this seemingly anomalous reading is as follows, albeit in fairly broad strokes:

• Federal Reserve money printing in the form of $85 billion/month in Quantitative Easing creates significant excess liquidity in the financial system.  Some of this money ends up sloshing into stocks.  The Bank of Japan’s recent announcement to pump even more capital into its system is adding even more fuel to this fire.
• Global economic reports of late have been disappointing, spurring belief among market participants that the era of low interest rates and central bank liquidity operations will continue longer than previously thought.  It might sound weird – because it is – but that is good news for stocks if you believe the prior point.
• The global financial system is now more concentrated than before the Financial Crisis, meaning that large institutions, primarily banks, have the explicit backing of the world’s governments.
• Interest rates are so low that capital must shift to stocks to achieve reasonable returns.  This process is very slow, however, begetting the “Grind higher” type of equity market we witness on virtually a daily basis.

Yes, these are ultimately unsatisfying answers, I grant you.  Offsetting those points is one simple fact: global economic growth is slow and listless, meaning that recession stalks the ongoing rally like a wolf around the flock.  Investors may be moving into stocks for their potentially higher returns, but the uncertain outlook means they are electing to put money to work at the low-volatility end of the equity risk-return continuum.  If there is less demand for the options-based “Protection” which the CBOE VIX Index ultimately tracks, it may well be because low-vol investors already feel hedged by virtue of their allocations.

Thinking outside the box for a moment, there may well be larger forces at work than just central banks or asset allocation dynamics.  Perhaps the historical comparisons the VIX of old don’t properly account for how the world has changed.  A few thoughts here:

• The role of technology and data analysis in corporate decision-making.  The last 20 years have brought us the Internet, social networks, mobile computing, and huge leaps in database analysis.  Large corporations have more useful information than ever before to understand their customers, supply chains, competitive position and cost structures.  It’s as if the Porter Model went from spreadsheets and 50 page board presentations to real time analysis and highly predictive models, all in about 5 years.
• While I have not seen much study on the subject, there does seem to be a strong correlation between this new level of business insight and the level of corporate spending, especially on new hires.  Perhaps firms are able to do more with less – the classic substitution of capital for labor.  Or, the explanation may be that businesses no longer add staff or investment in the hopes of a stronger recovery.  This was the traditional approach, after all, and gave economic recoveries some momentum to reach escape velocity.  Either way, the new and larger role of technology in corporate decision-making may well be reducing the volatility of earnings and therefore the equity markets overall.
• Less competition in many industry sectors.  Recessions do have value, despite their tremendous human cost.  Economic expansions always misallocate capital somewhere.  In the 1990s, it was dopey Internet companies.  In the 2000s, residential housing was the epicenter of a large bubble.  Even the 1980s had its overinvestment in sovereign and high yield corporate debt.  And in every case, the subsequent recession cleaned up the mess and set the table for the next party.
• We’ve been through a harsh recession and a disappointing recovery, which means that lots of capital left the economy and not much has returned.  And, as we’re seeing with the current record high levels of corporate earnings, this isn’t all bad.  Moreover, equity markets don’t just look at today’s bottom line; they also try to discount how long into the future they might last.  Less new competition, because businesses large and small do not want to take risks, is predictably good for the stock prices of existing companies.
• What’s really new?  One reason why the Financial Crisis hurt markets and global economies so badly is that very few policymakers really saw it coming.  That meant that they had no toolbox of solutions at hand to deal with the liquidity crisis after Lehman Brothers or the meltdown of Greek financial system.  At the same time, they do – sort of – have a playbook now.  It’s a brute force set of plans, to be sure…  Some leverage here, a little deposit taxation there…  But it is a plan.
• To get market volatility to move higher, we may need a different kind of crisis from the one we’ve just finished.  It might be geopolitical, but something like North Korea doesn’t really fit the bill.  Too small… Too weird…  Maybe something health related, like the latest flu strains making their way around Asia.  Personally, I believe it could be a large-scale hack of a significant financial institution or government agency.  Computer attacks have gone global, after all, and are increasingly state sponsored.

In summary, there may well be other valid reasons for the low levels of market volatility at the moment.  And perhaps some explanations for why it may remain so.  In the end, however, the phrase “This time is different” is a useful warning.  It never ever is “Different”.  Until it is.