While volatility has been on the rise since last August, much of the past five years has been characterized by unusually low volatility. Today the VIX Index is around 15, roughly 25 percent below the long-term average. Looking at the futures curve for the index, investors expect volatility to rise back to around 20 by the fall. Even this may understate the potential rise in volatility. Volatility normally moves in tandem with credit markets. While financial market conditions have become easier, evidenced by tighter spreads, they are still considerably tighter than was the case two years ago. This suggests that volatility should rise back into the low to mid-20s.
Market Realist – Volatility is likely to remain high. What are the implications for stocks?
The above graph shows the volatility index (or VIX), which is a gauge of volatility (VXX) in the S&P 500 index (IVV) (VOO). Volatility has been relatively low over the last few years. VIX averaged 14 in 2014, which is much lower than the long-term average of ~20. VIX averaged 16.7 in 2015, mainly because of the sudden spike in volatility in August. The Markets have been more or less volatile since then. So far this year, VIX has averaged 18.4.
The reason behind the rise in volatility is the slowdown in China (FXI) and the inability of Chinese authorities to control the Chinese yuan. The slowdown in China led to a contagion, which sent commodity prices to multiyear lows. This led to a recession in commodity-exporting economies such as Russia (RSX) and Brazil (EWZ).
Global (ACWX) growth and estimates have been falling. This means that double-digit equity returns that we’ve been used to in the last seven years will be very unlikely. That said, we’re not likely to see a bear market in the United States since the economy is growing at a solid, although uninspiring, 2%.
Also, with the one-time effect of the higher dollar and lower oil (USO) prices likely to fade away soon, earnings could get into positive territory. That would give a fillip for stocks.