Don't Fear The "Fear" Index


The S&P 500 did something on May 26 that it hasn't done in more than 20 years.

The index did nothing.

Indeed, the difference between the S&P 500's high and low on that day was a mere 4.48 points, or an intraday swing of just 0.19%. That was the smallest percentage intraday swing since March 1996.

While most of the world's attention has been focused on the rather loud political climate we now inhabit, the stock market has been unusually stable:

• The first quarter of this year was the least volatile in more than five decades. The average absolute percentage change for each day of the quarter was 0.32% for the Dow Jones Industrial Average, the lowest since the fourth quarter of 1965.

• The S&P 500 was also rather quiet. Its average absolute daily percentage change for the first quarter was also 0.32%, its lowest since the third quarter of 1967. During the quarter, the S&P 500 had 15 days when the Index basically did nothing from one day to the next (a gain or loss of 0.10% or less) — something we haven't seen since the third quarter of 2004.

• The market's low volatility was not just a first-quarter event but continued into the second quarter. For example, in the ten trading sessions through May 8, the S&P 500 moved in a mere 0.82% range, the smallest range for such a period going back to 1980.

Recent weeks have seen a little wake-up in daily volatility, with the Dow Industrials dropping 372 points on May 17 and climbing nearly 200 points over the first two days of June to new all-time highs. Nevertheless, the CBOE Volatility Index, or VIX, posted its second-lowest monthly average ever in May and recently posted its lowest one-day level since 1993. Often referred to as the market's "fear gauge," the VIX is calculated using S&P 500 options prices. The VIX is the most widely followed barometer of expected near-term stock-market volatility.

The VIX's lows have caused a number of market watchers to fret. The index reflects a complacent investor populace, say the bears, a populace not recognizing the many risks to this market — expensive valuations, continued political turmoil, tightening by central banks, terrorist attacks, etc.

The bears argue that unusually low readings on the VIX have led to market trouble in the past. The previous two occasions when the VIX fell below 10 (for context, the long-run average level is just under 19) were in late 1993/early 1994 and late 2006/early 2007. According to Reuters, the one-year returns after those extremely low VIX readings lagged the returns for the one-year period prior to the low VIX levels. 

So should investors fear the fear index right now? Probably not, for at least three reasons:

• Reuters analysis, as is most research, was extremely time dependent — one-year periods. Research by Charles Schwab & Co. shows shorter periods following low VIX readings have been fairly decent for investors. For example, in the six months following the low VIX readings in late 2006/early 2007, the S&P 500 rose approximately 7%, according to Schwab.

• Keep in mind you are looking at just two outlier periods since the VIX was established. Basing investment decisions on such a small sample set can be dangerous.

• Even if volatility accelerates from current levels, nothing says the volatility cannot be to the upside. Go back to last year prior to the election. The market was characterized by an extremely narrow trading range. Beginning in early July, the S&P 500 closed within 3% of its then all-time high every day for more than 80 consecutive market sessions, something it hadn't done in more than 20 years, according to data from LPL Financial. Following the election, the narrow trading range was resolved with a sharp upside breakout, with major indexes moving to all-time highs.

Bottom line: Don't fall prey to the fear. Quiet markets can be highly profitable for investors. And if this market awakens from its quiet period in a bad mood, it probably won't be because of complacency, but rather problems with the three main engines of sustained market moves — interest rates, inflation, and especially corporate profits.

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