By Mohamed El-Erian
Over the weekend, a long-time market observer whom I greatly respect posed an interesting question on Twitter about the VIX, an index that tracks investors' expectations of stock-market volatility and is hence most commonly seen as a sort of "fear gauge." He wondered, given the index's extremely low readings, whether it should be renamed the "complacency" or "hubris" index.
He has a salient point, one that speaks to the prospects for financial markets and the policy implications.
On Friday, the VIX fell 8 percent to close below 11, down from a peak of more than 80 during the financial crisis and very close to its all-time low of 9.3, reached in December 1993. The apparent sharp disappearance of worry comes at a time when stock-market indexes, such as the S&P 500 and Dow Jones Industrial Average, have been reaching new record highs.
The most immediate explanation for the VIX decline was Friday's employment report, which pointed to solid job creation in the context of limited wage inflation. The report offered yet another data point supporting the view that the Federal Reserve will keep repressing volatility as it attempts to stimulate the economy through the channel of financial markets.
Some see the fall in the VIX as a comforting trend that enables greater risk taking. This group believes that it’s a good unbiased indicator of what lies ahead: The lower it goes, the stronger the case for taking on more investment exposure, even at elevated prices. If nothing else, lower volatility tends to attract additional dollars into the market, thus pushing prices even higher.
Others aren't so sure. They believe the VIX is a better reflection of the past than the future. As such, its investment implications are limited. They worry that the low volatility readings, which tend to occur near market peaks, could be lulling investors into a sense of complacency, luring them to take risks that will set them up for a fall.
In parsing these two views, I would stress five points:
The VIX tells us more about past and current conditions than about future ones.
Its fall is now more a reflection of Fed policy than of self-reinforcing market forces.
At its current low levels, the VIX suggests investors may be overly impressed by the longer-term power of the Fed to maintain stability, and may be excessively downplaying fluid fundamentals.
The persistence of such low volatility will depend on more than an unchanged Fed policy stance. It will also require that regulators' macro-prudential oversight of the financial system be much more effective than has historically been the case (the topic of a coming column).
The VIX shouldn't be seen as a signal that now is a good time to increase long positions in the stock market. Instead, for those who are able to, the best way to exploit the unusually low readings on the VIX is through stock options, whose pricing is unlikely to stay as attractive down the road.
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