How Low Volatility Is Helping the 2017 Market Surge
Low volatility in the market
The movement of the volatility index (VIX) depends on market reaction. The index is surprisingly low amid the uncertain political climate and rising interest rates. Currently, the volatility index is at 11.6, a fall of 31.0% compared to the same period in 2016. The reasons for such low volatility include declining stock correlations and expectations of improved economic conditions in 2017. The following two factors drive index volatility:
- individual volatility of stocks
- correlation of index stock price returns
When considering a volatility index, it’s important to understand the correlation of the stocks in the index. When all stocks in an index are going up and down in parallel, the correlation is high, or positive. When individual stocks or sectors are moving in opposite directions, the correlation is low, or negative. Correlation is treated as equal to volatility since the index is expected to swing a lot if the correlation is high, and vice versa. Since the correlation between stocks in the index is low, implied volatility will remain low, driving market performance in 2017.
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VIX in 2016
November 2016 saw the volatility index fall to its lowest level since the 2008 mortgage crisis. The CBOE Volatility Index (or VIX) fell 23.0% on November 9, 2016, the largest one-day fall since early 2016. However, the VIX rose 12.0% on January 30, 2017, making it the largest one-day rise since the beginning of November 2016. But in spite of the recent spike in the volatility index, the 11.0 level is still low compared to the last five years.
Markets rise as volatility falls
Stocks are currently following the rally largely due to President Donald Trump’s policy announcements, thus holding volatility low. In 2016, the financial and industrial sectors performed well compared to the healthcare and real estate sectors. The net impact on volatility due to these sectors is relatively low, resulting in the fall in the volatility index.
The financial (XLF) and industrial (XLI) sectors posted gains of about 20.0% and 17.0%, respectively, in 2016. Some of the companies in the financial sector include Bank of America (BAC) and Citigroup (C).
The healthcare (XLV) and real estate (XLRE) sectors fell about 4.0% and 1.0%, respectively in 2016. Some of the companies in the healthcare industry include Cardinal Health (CAH) and Johnson & Johnson (JNJ).
For more information on global trade and the outlook for 2017, check out Market Realist’s Global Economy in 2016 and Expectations for 2017.