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The VIX Volatility Index Is Low, But I'm Still Worried About Volatility

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The VIX (officially, the CBOE Volatility Index) closed the day before this writing at 13.77 and as of this writing, is down even further, to 13.39. It’s not an all-time low, but the index closed higher on 80.4% of the days since 1/2/90 and on 83.5% of the days over the past year. So it really is l-o-w. Despite that, I continue to invest assuming we’re in a high-volatility market environment.

One Picture Worth Many Words

In case the above doesn’t convince you that the VIX is Low with a capital L, check Figure 1, which charts the trend since January 1990.

Figure 1

I assume that makes a convincing case.

From Label to Glossary to Reality

The index itself is sort-of cool. It sounds chic to speak of volatility rising or falling. It probably makes for good marketing opportunities: There are ETFs that use it and in 19 cases, include it in their names.

From the name of the index, it seems as if it measures volatility. That suggests my fear of volatility is off base, guarding against something that isn’t here, like wearing a winter coat on a hot summer day.

Actually, though, the VIX is a derived expectation of future volatility. It’s the number that’s required to make a bunch of options on S&P 500 stocks turn out to be correctly priced. Generally speaking, options are priced based on the stocks’ current price, the option’s strike price, the time to expiration, interest rates, and expected volatility.

All of those numbers, except for volatility, are known. So, too, is the market price of the option. As it turns out, forecasting volatility is incredibly difficult. So as a practical matter, the Street turns things around. It uses the market price of the option as an input into a model that, along with the other known items, spits out a number that represents the volatility estimate we’d have to plug in if we are to assume the option is price correctly. This is known as “Implied Volatility” or IV.

The VIX index is based on IV figures for a bunch of options on S&P 50o stocks.

That all sounds so logical – doesn’t it. Based on it, we can look at the 13-14 range for the VIX, say investors are expecting the market to be relatively stable going forward, and that I’m out of my mind with my continuing insistence on a low-volatility portfolio.

Reality check: Investors are assuming no such thing. We actually don’t know what anybody is assuming unless we ask them and we couldn’t; say what the investment community as a whole assumes unless we conduct a competent survey. IV is a mathematical construction that is labeled an expectation. But just because mathematicians label something as being so doesn’t mean it is so. If the model is wrong – i.e. if the mathematical constructs don’t represent reality as effectively as its proponents say it does – then all bets are off.

Personally, my mathematical background is not nearly sufficient to even think about deconstructing and critiquing the formulations that give rise to IV. But my understanding of the market tells me that we remain in a very high-volatility environment and if the math geeks disagree, they need to go back to the drawing board. (Maybe they should be measuring the change in the rate of IV, the “first derivative,” or maybe even the pace at which volatility expectations are changing, the “second derivative.” I’m so proud I could say that, but I better quit while I’m ahead, assuming I didn’t already screw up the calculus nomenclature.)

A Market Person’s View of Volatility

Yeah, yea, I know how to calculate Variance and Standard Deviation, and some other things. But for this, I’d rather look at a picture (Figure 2) of the S&P 500.

Figure 2

Look at the recent rates of change, the two sizable drops and recoveries in the lattermost period. That’s volatility.

That’s also the past. Is it likely to persist? We can’t tell from the data; as we know, past performance does not assure much of anything. We need to bring in market logic.

Stock prices are based on fundamental wealth (dividends, earnings, sales, cash flows, etc.), expected growth in fundamental wealth, and required rates of return a large component of which is market interest rates. The Dividend Discount Model (which sets the fair price at dividend divided by the difference between required return and expected growth) and all the more practical workable variations put interest rates into the lower portion (the denominator) of a fraction, which means that all else being equal, as interest rates fall stock prices must rise and as interest rates rise, stock prices must fall.

The epoch relentless multi-decade decline in interest rates has been a major factor in the generational bull market (interrupted by some crises here and there) we experienced for much of the time from 1982 through 2014. The 10-Year U.S. Treasury is charted since 1990 in Figure 3.

Figure 3

Notice the stock market’s recent increase in volatility occurred as the 10-Year Treasury ran out of room to keep falling.

But, one might say, it can still fall. It remains above zero, almost 2 percentage points (200 “basis points”) above zero.

Bear in mind that the 10-year is not the lowest-rate Treasury offering. Figure 4, for example, charts the 3-month Treasury, which, for the most part, should yield less than the 10-year (to compensate for a lesser time to maturity and, hence, considerably less market risk).

Figure 4

It’s not actually zero (as well it shouldn’t be since there are even shorter-term instruments), but many rounding conventions make it indistinguishable from zero.

But, says Mr. Bull, the spread between the 10-yeare and the 3-month could narrow (i.e. the 10-year could fall even as the 3 month doesn’t), and we might even have negative interest rates (i.e. taxes penalizing excess liquidity).

That’s true. But these propositions are stupendously debatable. So, too, would a suggestion that stocks could be helped by stable interest rates, i.e. rates won’t fall but they won’t rise either meaning stocks can grow based on earnings and growth expectations.

That’s too, is possible. But seriously – how often does one see a prolonged period of stability in anything economic or monetary. Does it happen often enough to make it a widespread expectation? To generate low volatility, we need not only interest-rate stability, but also, sufficiently widespread confidence in stability to allow us to not even think much about or debate the topic. That’s not happening. The “best” case scenario for interest rates is that they don’t go up but that the prospect of future increases remains serious enough to preserve debate over what to expect and that is the essence of market volatility.

What about earnings and growth, etc.? We always assess and argue about these. But now, it’s different. Now, we not only have to debate whether the next earnings season will be good, whether companies will meet or beat guidance, etc., but now, good isn’t good enough, or at least not in the context of what good meant over the past 35 years, when interest rates were racing downward. Now good has to be better than we’ve seen since before 1980; i.e. good enough to power stock prices forward even as interest rates rise.

That may happen. I hope it happens. And actually, I think we can get enough in this regard to offset what I think will be a slow pace of interest rate increases. But is this so obvious as to hardly warrant debate? No way. This is another breathtakingly debatable proposition. And breathtakingly debatable propositions regarding market-related expectations are the essence of volatility.

So I don’t care what VIX is. Standard deviations don’t interest me because those are just historical report cards that say nothing about the future. I care only about the level of confidence in the persistence of factors needed to justify higher stock prices and that level is lower than it’s been in a long, long time. So I’m continuing to lean toward stocks I believe can perform relatively well when in a high-volatility environment.

What To Do, What To Do

It’s easy to want low volatility portfolios, but less easy to implement this. The problem is not in identifying low-volatility stocks. The problem is adopting a low-volatility mindset.

That necessarily involves a willingness of accept lesser gains than would otherwise be possible during good times. This is a matter of market logic, not math or folklore. Relative stock stability comes from relative earnings stability (which comes from relative sales stability and/or relatively less debt-heavy balance sheets). So that which diminishes downside moves also inevitably diminishes upside moves.

Also a low-volatility mindset requires a willingness to pay up in terms of valuation. As noted, the ideal stock-pricing model includes required rates of return in the denominator of a fraction. Besides interest rates, the other component of required rate of return is risk. As risk goes down, all else being equal, price goes up, and vice versa. Think of it as akin to paying extra for protection against loss from auto accidents, fire, etc. Mitigation of losses is likewise a valuable thing, for which we must pay, in the stock market.

I implement my low-volatility strategy through the rules-based Low Volatility Select – SP 500 portfolio created by yours truly on Portfolio123 and available for free in the site’s Smart Alpha section. Figure 5 shows performance since the model went live.

Figure 5

As indicated, the model has been meeting expectations in that it has been diminishing the extent of movement in both directions.

The portfolio is due to be refreshed in mid-June (once every 13 weeks). Table 1 lists the current positions.

Table 1

Ticker Company
$BCR Bard (C.R.) Inc
$BF.B Brown-Forman
$CHD Church & Dwight
$CL Colgate-Palmolive
$HRB Block (H&R)
$HRL Hormel Foods
$HSY Hershey
$ISRG Intuitive Surgical
$JNJ Johnson & Johnson
$LLY Eli Lilly
$MCD McDonald's
$MO Altria Group
$PM Philip Morris Intl.
$PSA Public Storage
$ROST Ross Stores
$TJX TJX Companies
$VAR Varian Medical Systems