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Market Insights – Volatility Measures and Opportunities

“When a measure becomes a target, it ceases to be a good measure.”

Charles Goodhart

 

Goodhart’s Law, first introduced in 1975, suggests that once an observed empirical relationship begins to be widely used for decision making, it will no longer work. Goodhart’s Law was first applied to economic, social and educational measures. However, it can also be applied to financial markets.

The volatility index known as the VIX (Chicago Board Options Exchange Volatility Index), which measures the level of fear in the market, is one such example. The VIX is one variable that has had the bad fortune of being overused and overanalyzed such that its informational content has significantly decreased over the years. When it was first introduced in 1993, portfolio managers used various VIX measures to generate outperformance with short-term trading strategies such as the “4-day mean value”, or “rolling 30-day standard deviation”. The more traders that used short-term strategies based on the VIX, the more excess returns diminished. There are, however, still important insights that can be gained from this key gauge of the fear level in the market. What can large changes in the VIX tell us about asset allocation strategy?

Looking at volatility more broadly – what do investors make of scenarios where government bond volatility suggests calm waters, while equity volatility points to turbulent ones? Or, when the price of insurance for one day costs more than insurance for three months? Both circumstances exist today. Is there information to be gleaned from this irrational behavior? Historically, under both of these unique scenarios, investors have experienced a decline in equity market volatility and positive returns over the next 12 months.

There is a little rule that many strategists keep to themselves. It suggests that better predictive information can be found in the fixed income markets as they lead equities in pricing in changing expectations. The fixed income market is smarter than the equity market as less noise translates into better information.

The chart below displays volatility futures in the US Treasury market (fixed income). The significant decline in how investors have priced insurance suggests that the worst is over for the Covid-19 crisis.

The next chart shows volatility in the equity market. It suggests that the price investors are willing to pay for insurance to hedge their portfolios is still significantly above levels seen before the Covid-19 crisis began. History suggests that volatility levels in equities over time revert to similar levels as fixed income, all things being equal. The simple rule to apply to risk assets is that as volatility declines, prices for risk assets increase.

Combining the volatility of the fixed income and equity markets together to make a new signal for when extreme divergent views exist, we obtain the relationship depicted in the following chart. Going back to before the Great Financial Crisis, we see that the views between fixed income and equity investors are at an extreme level. If history repeats itself, then investors in the equity market should expect a significant decline in volatility throughout this year. Of course, this assumes that the economy slowly opens, and that science works to control, contain, and slowly eradicate Covid-19.

When we look at the term structure of equity volatility contracts to buy insurance for equity protection in a portfolio, we see another anomalous relationship. Namely, equity investors are willing to pay more for insurance for one day than they are for insurance for three months. This violates the basic rule of the “time value of money”. Simply put, the longer the contract, the more that can happen, and the higher the cost of insurance. This is not the case today! The following chart depicts the relationship between the different insurance contracts. If we can use history as a guide, then the price of one-day insurance will slowly approach the price of three-month insurance; and as the price of one-day insurance declines, equity prices should increase.

The table below contains the 12 month returns of various equity asset classes. Past performance does not guarantee future returns, but it does give investors a guide to frame their expectations. Going back to 2007, there have been seven episodes of extreme divergence between volatility in fixed-income and equity markets. Looking at the term structure of the VIX contract, or the time value of money, we see five episodes. The cut-off point for each data set below was chosen based on the most extreme cases.

In summary, periods of extreme volatility have historically presented equity investors with opportunities. At present we observe the following:

  1. Extreme divergence between volatility in the Treasury market (fixed income) and equities.
  2. The extreme and irrational divergence between the short and longer-term volatility measures.
  3. Investors should expect a decline in short term volatility.
  4. A decline in short term volatility generally leads to higher stock prices twelve months out.

 

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The opinions contained herein are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Wellington-Altus Private Wealth. Assumptions, opinions and information constitute the author’s judgement as of the date this material and subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. All third party products and services referred to or advertised in this presentation are sold by the company or organization named. While these products or services may serve as valuable aids to the independent investor, WAPW does not specifically endorse any of these products or services. The third party products and services referred to, or advertised in this presentation, are available as a convenience to its customers only, and WAPW is not liable for any claims, losses or damages however arising out of any purchase or use of third party products or services. All insurance products and services are offered by life licensed advisors of Wellington-Altus. Wellington-Altus Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. All trademarks are the property of their respective owners.