Is Volatility Too High? Goldilocks Says it’s Just Right

Well, I am fresh back from vacation in Northern Michigan.  I had the pleasure of driving over the Upper Peninsula twice during this trip to pick up one of my daughter’s from camp.  That’s three trips over the UP this summer, but, sadly, only one pasty.

From my perch up north, the big story for me was seeing volatility spike up for the first time in what seems like forever.  When stocks dropped by more than one percent on August 10th, it was the first time in 76 trading days that stocks hadn’t moved by a percent either way – the seventh longest such run in history.

The CBOE Volatility Index, or VIX, jumped from a close of 11.11 on August 9th to 16.04 the next day, a 44.3 percent increase.  Although it subsided in the following few days, it spiked again last Thursday to 15.55 and closed Friday at 14.26.

In case you’ve forgotten, the VIX is the implied volatility for the S&P 500 in the coming three months based on options for the S&P 500.  Traders don’t know the future, but how much they pay for options contracts on the S&P 500 does signal how much volatility they expect.

We’ve written a number of times about the low volatility that we’ve enjoyed recently (here and here, for example), but I have to admit that I don’t mind seeing the volatility in the market.

For me, when markets are super quiet, it’s like the point in a horror movie when someone is looking around in a dark basement trying to see what is making that weird noise.

Maybe that’s not a great metaphor since I don’t necessarily think that we’re about to be attacked by a guy in a hockey mask.  In fact, 10-years ago, I was in Michigan when the two infamous Bear Stearns hedge funds blew up that signaled the start of the financial crisis.  Let me say it unequivocally – I don’t think there is anything like 2008 on the horizon.

That said, a low risk environment can cause people to take excess risks, an idea put forth by economist Hyman Minsky, who taught right here in St. Louis at Washington University.  He argued that prolonged periods of financial stability and prosperity seeded instability as the economy takes on more risk than it can handle.

So, I’m sort of funny in the sense that I don’t like volatility that’s too low, but I also don’t like volatility to be too high.  I like it to be average, or ‘just right, like Goldilocks.  For me, that means that the VIX is somewhere in the mid- to high-teens.  The close last week doesn’t bother me at all, it’s actually still below the long-term average, which is around 18.

Now we’ll just have to see what actually happens with volatility in the coming months since, as I said before, traders often get this wrong and usually their estimates turn out to be too high in retrospect.  As I say, I am personally relieved to have some volatility back in the market, since without risk, there’s no reward.

I always enjoy vacation, especially to Michigan, but it’s nice to be back in the office too.  Many thanks to Cliff and Tim who wrote terrific Insights while I was out, which you can find here and here if you missed them.