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Investors are paranoid about low volatility, and rightly so. A market crash may be due

Investors and policy makers who have worried about the historic slide in stock volatility the past year might have had good reason to do so: most market crashes are preceded by exactly that pattern.

Investors are paranoid about low volatility, and rightly so. A market crash may be due

Investors and policy makers who have worried about the historic slide in stock volatility the past year might have had good reason to do so: most market crashes are preceded by exactly that pattern.

A study of 40 financial-asset bubbles conducted by researchers including Didier Sornette at the Swiss Finance Institute concluded that in about two-thirds of the cases the crashes followed a spell of lower volatility — the “lull before the storm.” The study didn’t comment on current market levels.

“Our main finding is that volatility is neither a reliable indicator of the maturation of a bubble nor of its impeding ending in a crash,” Sornette and his colleagues wrote in a study posted last month. That, in turn, casts “doubts on the supposed general relationship between risk and return,” they concluded.

The CBOE Volatility Index — known as the VIX — is on track to record the smallest daily swings over the full year since 2009, even after a jump last week triggered by tensions over North Korea. Taken alongside a lack of “pullbacks” in other equity gauges round the world, “we’ve never seen anything like this before,” Ryan Detrick, a strategist with brokerage LPL Financial based in Charlotte, North Carolina, wrote in a note last month.

What History Says About Today’s Subdued Volatility

The study by Sornette and his team suggests that keeping an eye on gauges like the VIX will prove little use in monitoring for any impending asset-price collapse. The group found no systematic evidence that increasing volatility can be used as an early-warning signal that a bubble is present or developing.

Bubble Endgame

“Sometimes volatility does tend to increase, often it decreases before the crash, and most of the time volatility barely changes as the bubble develops towards its end,” they said.

Other researchers have linked high volatility with bubbles. For example, Harold Vogel and Richard Werner, writing in the International Review of Financial Analysis in 2015, suggested that a rise in implied volatility foreshadows a bubble or crash. More recently, some analysts have expressed concern about the current low levels of U.S. stock volatility, with Dhaval Joshi, a BCA Research Inc. investment strategist, saying they amounted to a “ ticking time bomb.”

Why Traders Are Worrying About Low Volatility: QuickTake Q&A

The events studied by the Swiss team happened between 1929 and 2011 and included the U.S. dotcom bubble in March 2000, the 2010 sugar bubble, equity bubbles in Europe, Asia and South America, and the U.S. stock market bubbles of 1929 and 2007.

Very low volatility was seen at the crest of eleven of the bubbles, including the U.S. in 1962 and Hong Kong in 1987. The researchers wrote: “They are cases of investors being deaf, dumb and blind for the risk of the impending crash, investors that are only focused on riding the bubble to score a short-term profit during the strong price acceleration.”

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First published on: 16-08-2017 at 13:43 IST
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