What is Volatility Telling us About Markets
Another factor in our Probable Return on Investment Index, PRO-II (pronounced Pro Eyes) Indicator is volatility. We look at two aspects:
1. Expectations for volatility for the next month vs. volatility 4 months from now.
2. Current level of volatility relative to recent trends (quarterly average)
Last week these indicators told us to be concerned as current volatility spiked relative to expectations a few months from now. This week the forward curve is back to normal levels. Historically, a period of higher risk (days to weeks) did not develop this time. Historically, when the volatility curve inverts, we are close to a buying opportunity.
The volatility of volatility is keeping overall levels elevated and suggests the quality of the market rally is of much higher risk than just looking at the new price highs would suggest. Considering stocks are at all-time highs, one would think volatility would be close to all time lows—that’s the norm like in the 2017 rally. The fact that volatility remains elevated overall speaks to the more speculative nature of the current market environment. When does the asset bubble that central banks have created pop? When they stop inflating it with stimulus we suspect. That does not appear to be any time soon.
The very long-term average volatility reading (VIX) is in the 15-18 range (in line with the annual 100-year standard deviation of returns). The black dashed line on the chart shows that longer-term (4-year) average. The chart shows an inverted VIX futures level (green) with the 3-month average vix (red). In 2017, during the rising market, the average VIX was well below the historic number. When the Fed started to raise rates in 2018 following the tax cut Bill, we started to see the average level of volatility increase. We are far from a normal healthy volatility level. Market makers are demanding much higher risk premiums both on the call side and the put side. Truly a remarkable situation. It speaks volumes to the moral hazard the central banks have created to reflate asset markets. Any hint of them raising rates or backing away from stimulus may be the next signal that the bubble is about to break.
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