The CBOE VIX Index (VIX)—an estimate of future stock market volatility—has touched lows not seen since the pre-financial crisis days of 2007. That raises an intriguing question for technical analysts: Does this bode well or ill for stock prices as we head deeper into 2013?
The bears point to historical examples when low VIX readings of below 20 were followed by violent market corrections and instability. (The VIX closed at 15.51 on February 28.) That’s essentially what happened several times between 1998 and 2002, as well as since 2008. According to this theory, investors tend to grow complaisant and make bad investment decisions when the market is calm.
However, a February 20 report (.pdf) by Wells Capital Management challenges that conventional wisdom. Wells’ analysts reviewed U.S. stock market data and volatility going back to 1990. Here are its key findings:
1) While there have been stretches historically when low volatility has meant trouble, there are plenty of counter-examples. There were long periods—between 1992 and 1996 or between 2003 and 2007—when the stock market performed well and volatility was relatively low.
2) If you pull out the wide-angle lens and go back to 1900, the average annualized return has been 50% higher when volatility has been below average compared to when it was above average. In the post-war era, low volatility periods produced gains 26% higher on average than choppy market conditions.
3) Valuations also improve in the calm waters of low volatility. “While the relationship is far from perfect, most major sustained PE expansions since 1900 have occurred during periods of persistently low stock price volatility,” the report notes.
Meanwhile, Sam Ro at Business Insider earlier this year pointed to a helpful chart produced by JP Morgan Asset Management in the firm’s 2013 market outlook looking at stock market volatility and the correlation in stock price movements. The take away: stocks tend to move up and down together in periods of market instability, which makes it harder to value stocks based on fundamentals.
If you find the low-volatility-is-good-for-stocks thesis persuasive, there are plenty of exchange trade funds designed to perform well in stable markets. (Here’s a comprehensive list from ETF DB.) Low volatility ETFs attracted $4.6 billion in inflows in 2012 and the trend is spilling over into 2013, according to Tom Lydon at Etftrends.
Also, if you are interested in investing in volatility arbitrage, check out Robert Zingale’s Covestor Volatility Mean Reversion model.