Decoding the VIX
How does the index reflect today’s disconnected financial markets?
BY Lewis Powell | September 1, 2017
We are seeing a disconnect in financial markets. While the global economic policy uncertainty index is elevated, the VIX (often referred to as the “fear” index) is near historic lows.
These indices have historically been very correlated, moving to elevated and depressed levels together and leading to a couple of questions: Why are they diverging and, perhaps more importantly, what are the implications of one being right over the other?
Comparison of Global Economic Policy Uncertainty and the Price of Insurance in Equity Markets (Source: Bloomberg – April 2017, Epoch Investment Partners)
In many ways, 2016 was the year of the unexpected and yet realized volatility has come in below implied volatility more often than not, particularly since U.S. President Trump was elected.
Volatility is usually associated with uncertainty, which you could expect to increase in the wake of an election that made a reality TV star the most powerful man in the world. During the same year (2016), the global policy uncertainty index spiked upward, rightfully, as the UK voted to leave the EU on June 23. Yet, we still see the VIX pushing downward.
Perhaps markets are getting bored and complacent – they might assume central banks will make sure everything is okay so there is no need to purchase insurance. I don’t know. But what we can do is examine the data.
VIX by the numbers
What the data shows, is a further disconnect between the way market participants are feeling and actual results. In the chart below, we see the disconnect in the hard and soft data. The chart shows two estimates of GDP in the US.
The yellow line is backward-looking and focused on actual hard data such as manufacturing numbers and auto sales.
The top line includes all those normal inputs to GDP estimates, but it also includes other less tangible estimates such as consumer sentiment and business confidence – soft data if you would.
Source: U.S. Bureau of Economic Analysis, Federal Reserve Bank of Atlanta and Federal Reserve Bank of New York, Beutel Goodman
Warren Buffett famously said, it is wise to be “fearful when others are greedy and greedy when others are fearful.” To be clear, I am not timing anything and I don’t foresee anything negative on the immediate horizon. But I do believe everything is cyclical in some way and that all appearances point to fear having left the building.
So what should trustees and stewards of capital be doing? In these times, they should be on high alert. Don’t be complacent and always resort to policy. Managing your managers is key. Question them on these topics and how they are managing risk and short term volatility in the quest for long term success. On this point, I would encourage you to read Scot Blythe’s interesting piece on managing risk across time horizons.
Many managers will tell you they welcome volatility as it provides an opportunity to buy mispriced assets as fear picks up and the market over reacts. But what about the other end, when volatility is low… and fear has dried up?
Am I the only one seeing all the uncertainty? Monitor your managers, monitor your asset mix, don’t get greedy as despite all the disconnect, the market has reacted with “all is well” as derived through such strong returns as we have seen on risky assets.
Lewis Powell is a consultant at Proteus.