Low Volatility May Spur Stock Market Crash: Filia

Rather than a cause for complacency, the record low volatility registered in the equity markets in recent years should spark great concern, according to Francesco Filia, CEO of Fasanara Capital, in an e-mail to CNBC. "I believe low volatility to be the result of years of monumental liquidity injections by major central banks and their reflexive effect on investors' behavior and the buy-the-dip mentality, expecting central banks to hold their backs," he told CNBC. "Low volatility leads to its own demise, as it leads to complacency, excess risk-taking, excess leverage and a vast correlation across investment categories: in the words of Hyman Minsky, stability is destabilizing," Filia added. (For more, see also: Low Volatility: The Calm Before the Storm.)

VIX Uptick

If low expected volatility really is a bad thing, per Filia, maybe investors should welcome the recent uptick in the CBOE Volatility Index (VIX). From a recent low of 9.15 on January 3, it has spiked up to a closing value of 17.31 on February 2, its highest reading since reaching 16.04 on August 10, per data from MarketWatch. Most of this recent increase in volatility has accompanied the 3.9% decline in the S&P 500 Index (SPX) from its record close on January 26 through the close on February 2.

Dow Plummets

Meanwhile, the Dow Jones Industrial Average (DJIA) plummeted by 665.75 points on February 2, only the ninth decline of 600 points or more in its history, per another CNBC report. However, this represented only a 2.5% pullback. The first drop of similar absolute magnitude, 617.77 points on April 14, 2000, delivered a 5.66% hit to the Dow, per CNBC. The difference is that the value of the Dow today is nearly 2.5 times what it was then.

Big Gains, High Valuations

Nonetheless, both the Dow and the S&P 500 still sport hefty gains from their bear market lows in midday trading on March 6, 2009, respectively 294% and 314%. A lingering concern is that soaring stock prices are partly the result of lofty valuations by historical standards. The forward P/E ratio on the S&P 500 has shot up from about 10 in 2011 to 18.6 as of January 25, per Yardeni Research Inc.

Good News, Bad News

Inflationary fears, which are pushing interest rates upward, also may be a factor in the February 2 selloff, Barron's suggests. More specifically, per MarketWatch, the U.S. economy added 200,000 new jobs in January, exceeding economists' forecasts by 10,000. The unemployment rate is at a 17-year low, 4.1%, and hourly wages jumped by 2.9% year-over-year, the biggest increase since the Great Recession ended in June 2009, MarketWatch adds. So, while these figures indicate a still-robust economy, and consumers with increasing spending power, the inflationary implications may be the overriding concern among investors, at least for now.

Predictive Value

The VIX provides a projection of volatility in the S&P 500 during the next 30 days, derived from a sophisticated analysis of options trading and pricing. While the VIX was not designed to predict stock prices, movements in the S&P 500 and the VIX tend to be negatively correlated. That is, according to most studies, when the VIX is up, stocks tend to go down, and vice versa.  That's why the VIX often is referred to as a "fear index."

On the other hand, analysis by BMO Global Asset Management, a division of the Bank of Montreal, finds that the highest levels of the VIX (values of 25 or more) correspond to the highest annualized returns on the S&P 500, nearly three times greater than the returns when the VIX was at its lowest (values of 15 or less). The lowest returns on stocks, they found, was when the VIX was in the middle range of 15 to 25. The BMO analysis was based on data from 1990 through 2016. Their conclusion, which provided the title of this report: "What does the VIX predict? Maybe not much."

Flow of Causation

A valid question regards the flow of causation. Does a rise in expected volatility as measured by the VIX cause a rush to sell today, or is it the other way around? The BMO report says that "the VIX is really just a reflection of the recently observed volatility in the market." They add, "Investors assume the volatility of the stock market tomorrow will look similar to the volatility of the stock market today."

Daniel Lacalle, chief economist and investment officer at Tressis Gestion SGIIC SA, an asset management firm based in Spain, offers the opposite view. "Even the mildest change in volatility as seen this week can cause abrupt moves in markets," he told CNBC, as quoted in the first story referenced above. Maybe the answer is that moves in the VIX and in the markets today can create self-reinforcing trends.

In concert with Filia, BMO acknowledges that extended periods of low volatility can lead to "lax risk management and excesses in the market." A "quiet period" for the VIX from 2004 through mid-2007, they add, saw the buildup of the housing bubble and over-leveraged banks, households and corporations that led to a financial crisis, a bear market and several years of high volatility.

More Worries

The Investopedia Anxiety Index is registering high anxiety among our readers. An extreme level of anxiety about the market is outweighing low anxiety about other economic and financial matters. If that were not enough, the growing prevalence and prominence of computerized trading strategies that mimic and feed off each other raises yet another concern. As in 1987, or during the 2010 Flash Crash, so-called algorithmic trading or program trading may cause a modest stock market pullback to snowball quickly into an avalanche of selling and a genuine crash. (For more, see also: Could Algo Trading Cause a Bigger Crash Than 1987?)

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