“Stock markets are too complacent.” We’ve heard a lot of this sentiment recently, prompted by the fact that the Vix index – a measure of volatility on the S&P 500 – has been near record lows. There’s just one problem with it: it’s wrong.
Markets are not people. Instead, prices are the unintended outcome of individuals trading for different motives. If prices are telling us something, it is often not what we think. Let’s take that Vix index. It is closely tied to share price volatility; the more the S&P has moved recently, the higher will be the Vix. Volatility however is a sign of how much traders agree.
Agreement in bubbles
If everybody wants to sell, prices will have to fall a lot to attract buyers. And if everyone wants to buy, they’ll have to rise a lot to attract sellers. We’ll then have high volatility. If, on the other hand, people disagree, sellers will find buyers (and vice versa) without prices moving. We’ll then have low volatility.
Volatility isn’t something determined by any individual’s thoughts. Instead, it’s an emergent process – a by-product of people acting for other reasons. This explains the apparent paradox of low volatility but high political uncertainty. Traders interpret uncertainty differently. Some, for example, saw Donald Trump’s presidency as positive for equities, and some as negative.
High uncertainty has therefore co-existed with low volatility. By contrast, high volatility happens when people agree; in 2008, everyone agreed things were horrible and in 2000 they had agreed the outlook was bright.
Confidence versus returns
We cannot, therefore, say low volatility is a sign of complacency: history tells us this. If this were true, we’d expect low volatility to push share prices down. In fact, overall the opposite is the case: since 1990, the correlation between the Vix index and subsequent returns on the S&P 500 has been slightly negative.
Let’s take another example – the idea that rising share prices tell us investors are more optimistic. Investors may expect larger future dividends or share buy-backs. Or they may simply be more willing to take risks. Higher future dividends mean shares are worth buying, as they promise more cash in future. A greater willingness to take on risk, however, points to lower future returns, because investors now accept a lower risk premium.
Failing to distinguish these two can be expensive. At the peak of the tech bubble in 2000, investors thought future dividends would be high. But in fact, the risk premium was low – and prices then slumped as investors realised their mistake.
What does it all mean?
Yes, prices convey information. But it’s no easy task to work out what that information is. In 2016, betting markets suggested the UK might vote to remain in the EU and that Hillary Clinton would likely be elected US president. Markets were certainly telling us something. They were saying that a few huge bets on “remain” and Clinton were skewing prices.
In both markets, most bets were placed on “leave” and on Trump. The weight of money distorted the odds. Most punters were right, though.
A simple-minded belief that markets are right can be expensive, as economists Brock Mendel and Andrei Shleifer have shown. In the mid-00s, many traders assumed that credit derivatives were fairly priced, offering slightly higher returns than government bonds in exchange for a little more risk. They therefore bought them.
Don’t chase the noise
But, say Mendel and Shleifer, they were “chasing noise”; prices were too high and buying drove them even higher. The upshot was a banking crisis, when those assets were eventually seen to be too expensive. Yes, markets often tell us something. But they do so in a whisper, and they often aren’t telling us what we think they are.
In fact, people already know this. Big changes in share markets have little effect on consumer spending. Spending held up surprisingly well in the crashes of 1987 and 2001-03. Spending fell in 2009 because of the banking crisis rather than falls in the prices of shares on the market.
The effects of share markets on wealth are small: people don’t trust the messages that prices send. And they are right not to.