At times of low share price volatility - when share prices shift little - it can be tempting to think this is a sign to invest. But does this idea really hold true?
The price of protection reveals expectations
There is a more precise measure of volatility, or at least of expected volatility. It’s the VIX index compiled by the Chicago Board Options Exchange. This is a measure of option prices. The idea here is simple. If investors fear that share prices will fall a lot, they’ll want to buy protection.
They can do so by buying put options – the right to sell a share at a pre-specified price. The more investors fear big price falls – that is, the more volatility they expect – the more they’ll want to pay for put options and the higher their prices will be. The VIX index measures these prices. An example might be when this index falls under 11%. That compares to an average since 1990 of 20%, and tells us that investors expect volatility to be low. They don’t want to pay much for protection against big price falls.
Should low volatility point to low returns? History tells us the opposite
You might think there’s an obvious inference here that investors are complacent and are underestimating danger. If so, share prices might be too high and are heading for a fall. To put this another way, there’s a trade-off between risk and return. High risk should mean high returns, and low risk should mean low returns. A low VIX, being a sign of low risk, should therefore point to low returns.
The thinking here is entirely reasonable. And wrong. In fact, history tells us the opposite. The correlation between the VIX index and subsequent moves in the S&P 500 – measured over one, three or six months – has been slightly negative since 1990. If anything, a low VIX predicts high returns. For example, in the mid-90s and mid-00s the VIX was low, but share prices subsequently rose. And during the crash of 2008-09, volatility was high, but share prices subsequently fell.
Low volatility is a sign that investors disagree
One reason is that volatility tends to feed on itself, with high volatility leading to high volatility and low to low. To see how this can happen, remember that low volatility is a sign that investors disagree. If some people want to sell and others want to buy, then share prices needn’t move so we’ll have low volatility. But if lots of us agree that the market is heading for a fall, we’ll all want to sell so prices will have to fall a long way before we can find someone willing to buy. Volatility will then be high.
Now, when we consider buying shares we’ll want to know whether investors in future will agree or not. If we suspect lots of people will agree to sell in future, we’ll not buy for fear of a crash. But if we believe that any sellers will find willing buyers, we’ll be happier to buy because there’s less danger of a crash. But how can we know whether people will agree or disagree in future? We can’t precisely, but one clue is what they’re doing now; if they agree today we might expect them to agree in future and if they disagree we might expect them to continue doing so.
This generates the pattern we see in share prices and volatility. When volatility is low – that is, when investors disagree – share prices tend to rise because potential buyers don’t fear a crash and so are emboldened to buy. Conversely, when volatility is high, would-be buyers are deterred by the fear that people will agree to sell in future. Their lack of buying means prices are more likely to fall. So we see high volatility leading to more volatility and to falling prices.
Does “Mr Market” mislead?
All this tells us that one common perception of the market is plain wrong. We often think of the market as if it were a person – the legendary investor Ben Graham coined the phrase “Mr Market” – and attach moods to it: the market’s nervous; the market’s complacent and so on. Common as it is, this metaphor can be downright misleading. Sometimes, prices don’t reflect any individual’s emotion, but instead are the unintended outcome of different people’s different behaviour. Volatility and the VIX index are an example of this. Low volatility isn’t necessarily a sign of complacency but is instead a by-product of the fact that investors disagree.
Even if we understand volatility, we can’t predict prices
So, does this mean that low volatility is a sign that we should buy shares? Not necessarily. Yes, low volatility has more often than not led to prices rising, there are many exceptions to this. Just because we can understand what causes volatility doesn’t mean we can predict where prices are going.