The CBOE Volatility index (otherwise known as the VIX), a measure of equity market volatility, has been at ‘exceptionally’ low levels since the start of the year, but this is lulling investors into a false sense of security, according to ETF Securities.
The VIX has averaged 11.2 since the start of this year to 7 March, well below its long-term average of 19.6, a level so low it only occurs 4% of the time.
This might seem like a good thing, but James Butterfill, head of research and investment strategy at ETF Securities, said other indicators “do not share such a placid view of the world” – for example, government bond yields remain low, suggesting low risk appetite.
In a report entitled “VIX & Tax promises lulling equity investors into a false sense of security”, Butterfill said the situation is “leaving equity market vulnerable to a sell-off in the event of further interest rate rises and disappointment from the US political administration”.
Although he accepts that infrastructure spending and the prospect of corporate tax cuts could justify such optimism, he said it is “puzzling” that political volatility in the US and Europe is not being reflected in the VIX, saying “the VIX fails to mirror the rise in fear”.
“This has led us to question whether then VIX is still a valid expression of market risk,” he said.
To determine whether this is the case, ETF Securities created its own model of the VIX, using the Bank of America Merrill Lynch’s Global Financial Stress index (GFSI) in combination with the US Economic Policy Uncertainty index (the former measures a broad set of risks, while the latter looks at news story counts related to economic policy, uncertainty and legislation).
Between 2001 to 2014, this model tracked the VIX very closely, but after than the two indices have deviated from one another, with the VIX remaining “abnormally low”. Butterfill said his model suggests the VIX should currently be closer to 20, a level associated with much higher market risk.
His concern is that the low level of the index has created a perception of low risk in markets, which could be a factor driving the Federal Reserve to raise interest rates once again, a move the central bank is expected to make on Wednesday (15 March).
He also questioned whether it is right for investors to be so optimistic given the high equity valuations, especially in the US market. According to the American Association of Individual Investors survey, investor sentiment in the US has reached “peak bullishness”. But the S&P 500 is currently trading on a trailing P/E multiple of 22x earnings, the highest since 2002.
Butterfill believes most of investors’ bullishness is in fact due to the corporate tax cuts promised by US President Donald Trump, but said it is likely these will be delayed as they need to be approved by Congress, while also highlighting the divisions in the Republican Part itself. He also sees a continued squeeze on profit margins, primarily due to rising labour competition, putting further pressure on US companies.
“In short, we believe equity markets are becoming too complacent, valuations are high at a time when margins are likely to be squeezed further, whilst many promised tax cuts may not come to fruition this year,” Butterfill said.