Market volatility, as measured by the VIX Index, has been at its lowest level for ten years during Q1-2017 (touching 9.97 on Valentine’s day). Market indices in the US and UK, meanwhile, have broken through highs dating back to the peak of the tech bubble (17 years ago this month).
What is the VIX and why is it important for private clients and their advisors?
The VIX Index is intended to provide an instantaneous measure of how much the market thinks the S&P Index will fluctuate in the 30 days from the time of each tick of the VIX Index. Measured every 15 seconds it can move incredibly quickly. Often referred to as the ‘fear gauge’, it quantifies current investor sentiment. On that basis, investors are currently less fearful about markets than they have been in a decade.
Interestingly, the Index does have the tendency to spook itself (think flash crash), as it did on Friday 21st August 2015, when intraday the Index broke through 50. Subsequently, the Index fell back to sleep and has remained dormant.
Skip forward to March 2017 and we find the Index at 11.07 (20.03.2017). Against the current backdrop of US Market P/E ratios of 25x, should we be fearless, or is positive investor sentiment suppressing volatility?
The illustration below highlights the ten-year relationship between the S&P Index and VIX and shows a strong negative correlation (r² of -0.68).
How long can the current momentum be sustained and, as managers, how do we prepare for volatility and adverse market conditions, whether they occur in the next 30 days or the next three years?
To address that conundrum, let’s first take a look at what keeps our managers awake at night?
- Developed markets’ P/E Ratios – UK and US on the wrong side of fair value at 25x?
- Snapchat’s IPO – is the Tech sector feeling like ‘99?
- Rate rises and inflation – bonds entering a bear market
- Geopolitics – will Trump disappoint? Outcome of European elections
- US Debt Ceiling – 6-month window to determine a solution*
*On the last point and for those of you who are following the continuing political and market apathy towards the current situation I include a very brief executive summary: on the 15th March the debt ceiling crystalised at US$20Tn, currently US debt stands at approx US$19.3Tn, US Treasury Secretary Steven Mnuchin has written to Congress to notify them of the impending sovereign liquidity crisis (cash balance at start of march $189Bn, current burn rate US$2Bn per day). As yet President Trump and Congress have taken no meaningful steps to address the issue, while markets and the media have shown little, if any, interest.
Our approach to addressing these and many more factors that could shift the momentum of markets is, to quote our Chief Investment Officer, to ‘keep calm and try to see the big picture’.
In practical terms, this includes seeking exposure to development market opportunities in Europe where P/E ratios are considerably lower (Germany 15.6x); taking profits from themes and rebalancing to neutral positions; using dynamic bond managers; including downside protection and volatility management strategies; and most importantly ensuring that portfolios are actively managed and globally diversified.
As James Sullivan (Star Manager of our Special Situations Fund) eruditely put it “We are prepared for bumps in the road…”.
(In my personal view, and not necessarily that of my fellow IMC members, I can see VIX touching 50 again before September. In fact, a good friend and partner of MitonOptimal in Brazil and I have a friendly wager on the outcome – let’s see who’s buying lunch on my next visit to Latin America!
Floors, Ceilings and Suppressed Volatility – A Long View
