Share markets have calmed down, as have most other financial markets. The S&P 500 Index is as relaxed as it was before the Global Financial Crisis broke in September 2008. Daily moves in share prices are confined to an unusually narrow range and the cost of an option on the market (insurance against volatility) has fallen accordingly, as we show below.
A similar benign pattern of modest daily moves can be observed of the JSE Top 40 Index as is also shown.
The volatility priced into an option on the S&P 500 is the Volatility Index (VIX), which is actively traded on the Chicago Board of Exchange. This index is sometimes described as the Fear Index. The more fear or uncertainty about the state of the world, the more investors struggle to make sense of it all, the more prices move in both directions. The theoretical equivalent of the VIX calculated for the JSE is the SAVI. In a global capital market where uncertainty about the future is a common denominator, the VIX and the SAVI move closely together. Force one winds in New York City translate into force one winds on the JSE.
Both the VIX and the SAVI may be understood as forward looking measures of volatility used to price options, but they appear to track actual volatility – measured as the standard deviation (SD) about average daily price moves – very closely. We compare the VIX this year to the 30 day rolling moving average of the SD of the S&P 500 below. Both measures of volatility have declined this year, indicating that investors generally have a much more sanguine view of the future prospects of the companies they invest in.
The stability of the global financial system appears well secured by QE in the US, while the Draghi pronouncement “to do what it takes” to shore up European sovereign credit has soothed the sometimes savage breast of Mr and Ms Market.
So far so very good. Lower volatility (less fear of the future and so less of a risk premium demanded of financial assets hence higher present values attached to expected earnings) has been accompanied, as it almost always is, by higher share values.
The relationship between share prices generally and volatility is consistently strong: when volatility is up, share prices move down and vice versa. The correlation of both the daily level of the VIX and the S&P 500 and percentage changes in both series since 2005 remains very high, of the order of (-0.60) or higher when levels are correlated and even higher (-0.74) when daily changes are correlated.
The good news about financial markets today is that volatilities are low and fear of some economic crisis apparently largely absent. The down side is literally that – if volatility is already so low can it go lower? and if not, can we expect share prices to go much higher? The answer is still perhaps so if the fear stays away. The markets may well continue to grind mostly higher as they have been doing recently. But the chances of a global event that would again frighten shareholders and their agents cannot ever be ignored.
It appears that markets are much more inclined to crash lower on bad news that may mean a change in the world as we know it, than to crash higher on good news. Good news seems to dribble in slowly, bad news can come crashing down on your head overnight. Let us hope that the flow of economic news continues to be mostly encouraging and volatility stays low and share prices grind higher.
Today the DJIA dropped 200 ponits in about 10 minutes into the close. Not a good sign. Foreign markets have actually led the declines. If the US markets decide to catch up to these foreign markets, then look out below. No signs of a bottom yet, just grinding it’s way down and chopping up most traders along the way. Next stop looks like the 2003 low. I did a study on the two big consumer stocks WMT (Wallmart) & MCD (McDonalds) and overlayed them against big companies. Check the Monthly charts. These two are just starting to turn dowm. The consumer is 70% of GNP and a big part of stock consuption as well. Another bad sign.