By: Brett Olsen – Nicholas J. Elward
There has been much discussion lately about how stock market volatility is at near historic lows. The Chicago Board Options Exchange Volatility Index®(or VIX)1, a measure of implied or future volatility, is at a level of roughly 10 as of June 30, 2017. If one looks at the history of the VIX, it has typically averaged closer to 20. Over the last 20 years, there has been only one other period of volatility this low, over the 2004–2006 timeframe. This period was characterized by economic expansion and a strong stock market as the economy moved out of the 2000–2003 tech bubble burst. This period of calm came to an end with extremely high volatility as we entered the Great Recession of 2008.
There are several factors that could cause the VIX to increase in the coming months; personally, we believe it may double. Here are four reasons why:
1) Geopolitical unrest – There continues to be concern among many market analysts around North Korea, Russia and a variety of Middle Eastern nations – including Turkey, Iran, Saudi Arabia, Syria, and Iraq. Depending upon what a small number of political leaders decide to do in their countries, in their regions, and even more widely, we could suffer increased global unrest, which may cause increased global stock market volatility. In addition to the actions taken by political leaders, the threat of terrorism remains unpredictable and could contribute to rising volatility.
2) Instability in the American political landscape – Ever since the election of Donald Trump in November 2016, we have seen strong stock market returns. The Trump administration has promised investor friendly policies, such as tax reform and deregulation. There are also expectations of more infrastructure spending, which could help increase business growth and employment in the United States. However, despite these expectations, there have been many distractions as these legislative goals are being pursued, including the ongoing investigation into the Trump campaign’s connections with Russia and continued disagreements between and among legislators of both parties. Each of these distractions has the potential to create further frustration among both business leaders and voters alike. Moreover, it remains possible that the investigations into the Trump administration could result in material changes in executive branch leadership. Current political dynamics have the potential to translate quickly into increased market turbulence.
3) Advance to the back-end of the US business cycle – The U.S. is in the 8th year of an economic expansion, one of the longest in history. According to historical data, most business cycles last an average of about 6 years. Considering the age of the current expansion, a sustained market correction – and the increased stock market volatility that could come along with it – may loom.
4) Retrenchment of central banks’ easy credit policy – The U.S. and many other countries across Europe have seen declining or very low interest rates dating back nearly 10 years. However, this business-friendly credit environment may be coming to an end in the U.S., and we expect soon in Europe as well, as interest rates are set to rise. In addition to this, the U.S. is likely to begin tapering its bond buying program later this year, which has also had an impact on keeping rates low. The ending of the Federal Reserve’s quantitative easing (QE)2 program will eliminate an artificial stabilizer in the economy. We expect this could increase the probability of higher stock market volatility in the near future.
Readying for the road ahead
With these volatility-increasing risks before us, we strongly believe the VIX could double within a year. This predication is just that, a prediction, based on the above risks and the fact that the level of volatility is currently at near historic lows. Nevertheless, we believe it stands to reason that the market will see a reversion to the mean and find the VIX trading in the 20+ range before too long.
In order to prepare for this greater level of volatility, investors should carefully review their portfolios so they are aware of the risks they are taking. A range of investment strategies, including lower volatility investment strategies, are available to investors looking to reduce risk and increase diversification in their portfolio.
1 The CBOE Volatility Index (the VIX) measures the implied volatility of the S&P 500® Index. The VIX is quoted in percentage points and represents the expected range of movement in the S&P 500 index over the next year. For example, if the VIX is 15, this represents an expected annualized change of less than 15%, up or down.
2 Quantitative easing (QE) is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
Volatility management techniques may result in periods of loss and underperformance, may limit the Fund’s ability to participate in rising markets and may increase transaction costs.
Diversification does not guarantee a profit or protect against a loss.
All investing involves risk, including the risk of loss.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.