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The VIX Mystery: Here's What Investors Need to Know

U.S. stocks put in yet another record high on Thursday, as the benchmark S&P 500 rose 0.5%. The narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) was up 0.4% to close within 10 basis points of its all-time high, while the technology-heavy Nasdaq Composite Index (NASDAQINDEX: ^IXIC  ) gained 0.4%. But while the S&P 500 may be at an all-time high, the volatility of the S&P 500, as measured by the CBOE Volatility Index (VOLATILITYINDICES: ^VIX  ) , is near multi-year lows. Speculators who gamble on the index using products including the iPath VIX Short-Term Futures ETN (NYSEMKT: VXX  ) and the Velocity Shares 2x VIX Short-Term ETN (NASDAQ: TVIX  ) ought to consider whether we have shifted to a new regime of ultra-low volatility. If so, all investors may want to ask why and what are the possible implications for the capital markets?

It doesn't take a lot of research to show that the VIX Index is near the bottom of its recent historical range -- a quick glance at the graph confirms it. (Derived from S&P 500 option prices, the VIX is a measure of investor expectations for stock market volatility during the coming 30 days.)

However, the following observations hammer home just how low current values are:

  • Last Friday, the VIX closed at 11.36, the lowest value it has achieved since March 14-15, 2013 (including on an intraday basis.) Prior to that, it has been more than seven years (March 2007) since we've witnessed lower VIX values.
  • At today's closing price of 11.57, the VIX is at the threshold of the bottom fifth percentile of values going back all the way to the inception of the index in Jan. 1990. That price represents a greater than 40% discount to its historical average from inception of 20.09.
  • The last time when we had a sustained period of values lower than today's was October 2006 through February 2007. Perspicacious readers will have noticed that period roughly coincides with the height of the credit bubble, during which investor (over)confidence was extraordinarily high.

It's not altogether surprising we should be here, considering that we're still in the midst of a extraordinary bull market run off the crisis bottom of March 2009. This year, gains have been more subdued, but the stock market continues to grind higher. More: The lack of any significant downside volatility to punctuate the rally during the past several years has undoubtedly contributed to the decline in the VIX. Assuming no market upset during the next 30-odd days and, by the end of next month, we will have gone 1,000 days without experiencing a 10% correction in the S&P 500. This is the third longest such streak on record, according to Bespoke Investment Group.

I'm convinced (as much as one can be in the field of economics and finance) that the Fed has played a key role in this decline, effectively suppressing volatility through the use of unconventional policy tools (notably, its multi-trillion dollar bond-buying program, known formally as "quantitative easing"). However, I did not expect volatility to reach these levels, in light of the enormous uncertainty that remains with regard to the strength and sustainability of the recovery and the Fed's ability to exit its policies gracefully.

Here's a hypothesis that could help explain these ultra-low values: The market may be adjusting to the idea that Fed policy will remain accommodative (particularly with regard to interest rates) much longer than it had previously expected -- which would continue to support corporate earnings and the multiple investors are willing to put on those earnings. That hypothesis jibes with a 10-year bond yield currently sitting around 2.5%, down from roughly 3% at the beginning of the year. (The consensus at the start of the year was that yields would head higher.)

Stock market corrections are a useful reminder that equities are risk assets and need to be appraised as such. More than ever, long-term investors ought to remain focused on business values in this slightly bizarro market. The Fed may well remain accommodative for a long time to come; nevertheless, market sentiment can shift suddenly. When it does, long-term conscious investors can remain tethered to their assessment of value.

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Read/Post Comments (2) | Recommend This Article (5)

Comments from our Foolish Readers

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  • Report this Comment On May 30, 2014, at 6:11 AM, JeffryClarke wrote:

    We certainly live in interesting times. We now have a combination of historically low volatility and historically low interest rates. Sure the market is a little overvalued by historical measures, but it still feels like a recipe for a bull market to me.

  • Report this Comment On June 02, 2014, at 7:39 AM, Blackhawk wrote:

    Jeffry - I must somewhat agree, but I'm basing this on a typical technical chart analysis of the VIX 500 which is showing returns to stable lower lows on a constant basis 'so far'.

    IMHO I think LONG TERM INVESTORS should also strongly consider the artificial propping vis a vis of stimulus vs QE in respect to Wall St. recommendations and actions as a consequence.

    I would haphazard a guess that since the correction of 'momentum stocks' most individual investors have been advised by their managers (and somewhat correctly) to bolster their positions (i.e. Managers get commissions every time you move) into defensive play stocks/funds/ETFs.

    For me...shift some 1/4 equity into short term bonds if you are nervous, but maintain a solid position where you are at............providing that you are a long term investor.

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Alex Dumortier

Alex Dumortier covers daily market activity from a contrarian, value-oriented perspective. He has been writing for the Motley Fool since 2006.

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8/27/2015 4:35 PM
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