With the VIX back to a 10-handle and eagerly eyeing single-digits once again, commentary on market complacency and the low VIX, which was blissfully gone for the past month when the VIX surged valiantly if briefly only to be smacked right back down, has returned. In a note from SocGen's Praveen Singh, the French bank analyst boldly goes where so many prognosticators have gone before, and looking at the evolving cross-asset volatility trends, warns that the market is "now entering dangerous volatility regimes."
Hardly stating the unknown, Singh writes that "expected volatility has been falling consistently. Over the last year, expected volatility has been falling on a consistent basis. When we look at equity and government bonds, the current level of volatility is well below long-term average volatility. Falling volatility normally means stable environment for risk assets."
So time for some (familiar) numbers: the current low level of volatility happens less than 2% of the time for equities. In the following chart, SocGen plots the distribution of equity volatility based on data since 1994. The bank's analysis suggests that average equity volatility has been above the current level 98% of the time. This means that volatility is more likely to go up than fall further from current levels... at least in theory, of course. In practice, what it means these days is that some central banks unload a few thousand VIX contracts to prevent any vol spike at just the right time.
Undeterred, SocGen presses on and warns that - central banks aside - in the past, equity volatility has bottomed at around current levels and rose subsequently. Volatility has a strong mean-reverting tendency.
"Hence, we observe that periods of particularly low volatility are often followed by periods of relatively higher volatility."
Of course, It's not just equities: The low level of volatility is pervasive across asset classes and as Singh shows in the chart below, "we compare the current level of volatility with the historical range. We find that for most asset classes the current level of volatility is near the lower end of its long-term range."
Again, none of the above is new, and it goes to one fundamental theme involving vol: mean-reversion, a phenomenon which always happens, yet which has been sorely lacking in the space for a long, long time. As such, all SocGen is saying is that "it's time"... but is it? Many traders have been crushed betting on an imminent vol surge, which never materialized. Why will this time be any different? Here's SocGen's rationalization:
How long can volatility stay this low? In the past, when equity market volatility was around the current level, it went on to rise by 3 points in the subsequent 12 months. In the below charts, we show evolution of equity volatility between 2007 and 2009. We note that:
- Equity volatility troughed in February 2007, around eight months ahead of the US equity market peak. The current level of equity volatility is very similar to what we saw in February 2007. Equity market volatility started to rise in the subsequent months.
- We note that the dislocation in equity market volatility is much greater than the dislocation in government bonds.
Finally, does SocGen's concern mean investors should get out of stocks? Well... not really. As Singh concludes, the current low level of volatility makes equities our preferred asset class as risk-adjusted return is higher. However, a subsequent rise in volatility means: i) Balanced asset allocation, i.e. 50% equity and 50% fixed income, is better than a more dynamic (higher equity) allocation. ii) Equity re-allocation i.e. avoid areas where risk-adjusted return is deteriorating (US equity allocation has been reduced in our latest Q-MAP balanced portfolio). iii) Increase cash allocation (our cash allocation has been increased from 5% to 10%).
So after predicting that a 2007 vol episode may be imminent (as a reminder, back then the VIX briefly tagged 80 in the process destroying all vol sellers), SocGen's brave reco is to increase cash from 5% to 10%. One may just buy bitcoin instead.