The CBOE VIX Index closed today at 10.11 (having traded with a 9 handle briefly intraday), which got ConvergEx's Nicholas Colas wondering what a single-digit reading may indicate about US stocks.
Three historical periods back to 1990 feature a sub-10 VIX: December 1993, January 1994, and Dec 2006/Jan 2007.
In each case, US equities were modestly lower (down 2 to 6%) one year later and in 2 of the 3 instances they were down 2-6% in three months’ time. More importantly, the following years (1995 and 2008) show a remarkable dichotomy of returns (up or down 37%).
So what has taken us down to these VIX levels? In today’s note we call out 10 different notional market “Puts” that each tend to dampen actual (and therefore near term forecast) volatility. These include Fed/ECB puts, a Trump/Republican policy put, a passive money flow put and a corporate cash put. Now, if you’re looking to understand when volatility returns (and it always does), this “Top 10 Market Puts” list a good starting point. When one or two begin to unwind, that’s when volatility will return. And not before.
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“It’s quiet out there… too quiet.” That old line, its origins lost to history, neatly sums up how many equity traders feel right now. Global equities continue their remarkable rally in the most unremarkable of ways. Slow, and steady and boring.
The CBOE VIX Index briefly broke 10 today, essentially half of its long run average of 19.6, and closed at 10.11. In its unofficial role as the primary forecasting tool of near term US equity volatility, that is the equivalent of a Los Angeles weather forecast. 80 degrees and sunny… Next weather update in 5 days.
I got to wondering just how many days the VIX has closed below 10 and what that means for future equity returns. The answers:
- The VIX has closed below 10.0 a total of nine times since 1990. There are three clusters on that timeline: late 1993 (December 22, 23, 27 and 28 1993), late 2006/early 2007 (November 20/21 with December 14 2006 and January 24 2007), and a standalone January 28 1994.
- Three, six and twelve month S&P 500 price returns after December 28 1993 were: -2.3%, -5.3% and -2.1%. (Worth noting – S&P 500 total returns for 1994 were +1.33%, but 3 month Treasuries returned 4.0%).
- Three, six and twelve month returns after January 28 1994 were, of course, similar at -6.2%, -5.1% and -1.7%.
- Three, six and twelve month returns after January 24 2007 were +2.8%, +4.9% and -6.1%. The following year was the bad one, with total returns for the S&P 500 of -36.6%.
The takeaway from these examples is clear: in the unusual instances (just 0.13% of the days since 1990) when the VIX closes below 10, one year forward returns have all been negative. In one case (2007 into 2008) the following year was terrible. In the other case (1994 into 1995) it was great – up 37.2%.
If you want to see a history of S&P 500/3 month T-bills/10 year Treasury note returns (very useful when looking at historical trends such as these), click here.
Important: the upshot of this quick analysis is this: a VIX close below 10 is historically correlated with a one year pause in S&P 500 returns. The year after that is where things get dicey. You could get a 1995 (+37%) or a 2008 (down 37%).
Now, 3 (2 and half, if we’re being honest) examples isn’t a great sample size. To round out the discussion we need to come to some conclusions about WHY US equity volatility is so low. And what might change that.
Here are 10 equity “Puts”: commonly held investor beliefs about current market dynamics that help explain both low volatility and the march higher for US and global equities.
#1) The Fed Put. Ever since Alan Greenspan came to the US equity market’s rescue after the October 1987 crash, there has been a school of thought that says the US Federal Reserve views equity markets as a “Third mandate” along with price stability and full employment. If markets falter, the Fed will pass on a June rate increase and perhaps those scheduled for later in the year as well. Or so the logic goes…
#2) The ECB Put. To the degree to which the European Central Bank has mimicked the Fed’s policies of ultra-low interest rates and the purchase of long dated bonds (quantitative easing), equity investors may well feel that there is also an ECB “Put”.
#3) “Long End of the Yield Curve” Put. If global economic growth is about to take a step function higher (as indicated by rallies in US, EAFE and Emerging Market equities) no one seems to have told sovereign debt markets. The US 10 year note for example, yields all of 2.3% and the 10 year German Bund pays a 0.3% coupon. Those low rates help support equity valuations, and if global growth falters those rates will go lower still (and continue to help valuations).
#4) “Trump/Republican Washington” Put. At some point before the mid-term US elections in 2018, President Trump and the GOP – controlled Congress should be able to pass tax reform. That gives equity investors the chance to see earnings estimates rise for 2018 and beyond, supporting current valuations.
#5) “Passive Money/ETF Flow” Put. Year to date money flows into equity US listed Exchange Traded Funds total $121 billion, a pace that will break all prior records if it continues through the end of 2017. Moreover, those flows are remarkably consistent whether you look at the last day, week, month, quarter to date or calendar year. As long as those trends continue, why worry about a market correction?
#6) “Offshore/Corporate Cash” Put. US public companies continue to operate at near-record profit margins, but they are still more likely to buy back their own stock or hold cash offshore rather than invest in their business with those cash flows. That leaves them less prone to financial stress during an economic downturn and therefore reduces their stock price volatility across the business cycle. Also worth considering: if corporate tax reform does come through, these same companies may be able to repatriate some of their offshore cash holdings for buybacks (which would also reduce price volatility, everything else equal).
#7) “Lower Sector Correlation” Put. Since the November US elections, sector correlations within the S&P 500 have dropped from +90% to 55-60%. Should this continue (and absent a major correction, it should), overall S&P 500 volatility will remain lower than when correlations were higher.
#8) “Earnings Beats GDP” Put. As it stands right now, the S&P 500 will post close to a 10% earnings growth rate for Q1 2017. Part of that is from smaller losses in the Energy sector, and part is actual earnings growth in Financials, Materials, and Tech stocks. All of it is enough to allow analysts to expect Q2 2017 earnings growth to run 8%, even though Q1 US GDP growth only showed 0.7% growth when it was released last Friday.
#9) “Receding Nationalism” Put. Now that equity investors seem certain Marine Le Pen will not be the next French president, the prospects for a “Frexit” seem distant. Polls currently have her at 40% of the vote versus Macron’s 60%. See here for a good poll tracker: http://www.bbc.com/news/world-europe-39692961
#10) “GDP Bounce Back” Put. After a lackluster Q1 GDP print, the closely watched (and accurate for Q1) Atlanta Fed GDP Now model has a 4.3% starting estimate for Q2 2017. Blue chip economists are sitting closer to 2.7%, but all agree for the moment that Q2 will be far better than Q1.
I could go on, but you get the point: there is an overwhelming market narrative that equates to “Don’t worry, be happy”. That should be no surprise. You don’t end up with a 10 handle VIX very often, and when you do it is the result of a unique set of circumstances.
I will close where I began, with the possibility of a single digit VIX reading. Historically, that signals the possibility of a pause in equity returns. This means at least a few of our 10 “Puts” will not actually work as anticipated. But the real question is not 2017 – it is 2018. Will next year resemble 1995 (+37%) or 2008 (-37%). Again, that comes down to how many of these “Puts” survive the next 12 months.