SHARP drop-offs in the volatility or “fear” index of the S&P 500 sparked a flurry of commentary last week as the indicator fell 11.5 per cent over one week to hit a six month low. The index (known as the Vix) is calculated by the Chicago Board Options Exchange using data from a range of S&P put and call options prices and is a measure of the market’s expectations of volatility over the coming month or “implied volatility”.
The index’s movement has prompted some analysts to predict a rise based purely on its unusually low level. But there are more concrete reasons why punters should place a long bet on this measure of uncertainty.
One is the sharp gradient of the volatility curve – that is, the price of volatility futures contracts. In fact, the spread between the volatility index’s spot price and the price of a February contract spiked to over 11 almost in tandem with the Vix hitting its lows. This means that although the markets might be calm right now, those who hedge by buying the Vix are anticipating a sharp rise in volatility over the coming months.
And there could also be a mathematical reason why the Vix should rise. In part of a recent letter to investors, Artemis Capital’s managing partner Christopher Cole theorised a connection between price correlation, volatility and quantitative easing that he dubbed a “unified risk theory”. According to the theory, the influx of liquidity that the Fed is soon expected to pump into the US markets should also lead to a sharp rise in volatility – but the timing of the events remains uncertain.
Cole reasons that periods of high price correlation between asset classes result in greater volatility: “Correlations typically rise sharply with volatility during financial crashes (like in 2008) as investors panic and sell all assets resulting in less information being embedded in prices”. Instead of buying based on the individual pros and cons of an investment, investors either buy in “risk on” mode (equities and commodities) or in “risk off” mode (bonds and gold). This means that an asset’s class, rather than fundamentals, determines whether it is bought or sold.
It is not only the cases that asset classes are more correlated than ever; large US equities are also more likely to move in lockstep. The correlation of the stocks that comprise the S&P 500 Index (pictured on the chart) has surged. This period of high correlation means that investors are liable to buy and sell all at once, meaning it should fall off and rise more unpredictably and more sharply. As Cole writes: “The implied volatility of an index, such as the S&P 500, is more sensitive when the average correlations between the components of the index are greater.”
So how does this relate to QE? Cole suggests that QE actively boosts correlations, because when the market is flooded with a one-time freebie of new cash (or when an influx is promised), buyers immediately try to spend their money as quickly as possible before it is devalued. This results in all asset classes rising together, with little differentiation for the quality of the asset in question. Of course, the timing and scale of QE are not yet clear, but even just the expectation of it seems to have prompted a spending spree, with gold, commodities, equities and bonds all rising together over the last month. Coupled with other sources of uncertainty such as currency wars and sluggish growth, high correlations and QE should push the Vix up in the coming months.