Why Volatility Plunging Near 20-Year Low Is Red Flag for Stocks

2019 has been an exceptional year for equity returns, and an unusually quiet year for volatility. That may not last, according to some strategists.

Mike Wilson, the chief investment officer (CIO) and head U.S. equity strategist at Morgan Stanley, says that a flood of liquidity from the Federal Reserve and other central banks, at a $1.2 trillion annual rate, has created an artificial 20-year low in volatility that is unlikely to last amid weak fundamentals. He outlined both the market risks and how investors should prepare for a volatility spike in a recent podcast.

Significance For Investors

Highlights of Wilson's comments follow, as transcribed by Investopedia.

"2019 has been a year in which the fundamentals have steadily deteriorated, yet equity prices have rallied sharply, More than 100 percent of the returns in equity markets this year have come from higher valuations, while earnings growth has been negative."

"Are stock prices simply looking forward and telling us earnings growth is going to rebound sharply next year? Maybe, but if that were the case we should be seeing other asset prices rebounding more than they are. More specifically, 10-year interest rates, commodity prices, inflation break-evens and cyclical stocks relative to defensive ones have actually rolled over recently, and in some cases sharply."

"Instead of stocks telling us growth is going to rebound sharply next year, we simply think they are responding to something else, a massive surge in central bank balance sheet expansion. To be specific, about two months ago the Fed, the European Central Bank, and the Bank of Japan began expanding their balance sheets by a combined $100 billion per month. That’s a lot of liquidity, and it’s undeniable it’s having an impact on asset prices."

"It’s definitely been a volatility suppressant. For example, over the past two months, 30-day realized volatility for the S&P 500 has plummeted, from over 21 percent to just five and a half. To put that in context, this is one of the lowest realized volatility readings in the past 20 years, the first percentile to be exact."

"That seems like a bit of a mispricing, given the negative earnings growth we’re witnessing, and ongoing trade war and other geopolitical tensions and a full-blown recession in global manufacturing. Due to the advent of systematic investment strategies that target volatility, the lower realized volatility has led to significant inflows to equity markets that are not fundamentally based."

"It’s also allowed, and forced, some active equity managers to hold more risk than they should, or normally would, simply because volatility is now underpriced."

"This is masking what’s really on with the fundamentals, and convincing many analysts, strategists, and even companies of a recovery next year that’s likely to disappoint now-high expectations. We’re not sure when this disappointment will manifest itself in the form of higher volatility, but we’re highly confident volatility is about as low as it can go, and when it turns, these passive and active strategies will quickly reverse recent flows."

"The result of recent balance sheet expansion has been the same for asset prices, which have become detached from fundamentals in the short term."

Morgan Stanley forecasts an increase in global GDP growth from 3.0% in 2019 to 3.2% in 2020, while U.S. GDP growth in 2020 will lag, at 1.8%. Partly as a result, they say: "Our earnings model is telling us that the consensus forecast of 10% [S&P 500] EPS growth in 2020 is likely to miss and actually be closer to 0%."

The CBOE Volatility Index (VIX) recently dipped to its lowest level since Aug. 2018, a bearish indicator for market contrarians. “The developments over the past weeks might support the usual narrative that investors are being complacent, and the idea that we could be in for another equity selloff,” as Hubert de Barochez, markets economist at Capital Economics, warned in a note cited by The Wall Street Journal.

Since its recent low close of 11.75 on Nov. 27, the VIX has risen to 14.61 as of the close on Dec. 5. President Trump's indication that a U.S.-China trade deal may be delayed has put many investors on edge.

Looking Ahead

"Our advice is to remain fully invested in global equities, while maintaining a tactical overweight to U.S. long-term Treasury bonds and volatility products as a hedge against the inevitable rise in risk aversion that can happen at any moment," Wilson says. Morgan Stanley's base case for the S&P 500 Index is that it will end 2020 at 3,000, or 3.8% below the Dec. 5, 2019 close.