Wall Street's favourite fear gauge has tumbled to some of its lowest levels in almost a quarter-century, raising concerns that investors have become too complacent about the risks surrounding today's frothy stock prices.
The pervasive lack of worry may signal that the market is underestimating the potential for economic mishaps. With Donald Trump in the White House and Vladimir Putin in the Kremlin, as well as a still dysfunctional euro zone and a slowing China, the potential for accidents is high.
Yet none of that distress is reflected in the volatility index compiled by the Chicago Board Options Exchange.
Known by its ticker symbol, VIX, the index uses stock options to measure the expected turbulence in the S&P 500 over the month ahead.
The VIX closed at 9.77 on Monday – its lowest finish since early 1993 – suggesting that investors have attained a state of zen-like tranquillity about today's stock prices, despite valuations that are way greater than historical norms.
The VIX rose slightly on Tuesday, but continued to hover around 10, an unusually low level. Over the past five years, it has spiked above 30 on several occasions and averaged just more than 15. The last time the VIX broke less than 10 after spending at least a month above that level was in January, 2007, according to Schaeffer's Investment Research. As investors will recall, that didn't turn out so well. The financial crisis erupted a few months later.
Today's rock-bottom VIX may signal similar ructions ahead. But analysts, including Barry Ritholtz of Bloomberg, argue that the VIX is more of a coincident indicator than a leading or contrarian indicator.
In other words, it signals what is happening, not what will happen.
The real danger this time out may not be that the VIX is wrong. The real peril could be if it's right.
If the VIX is correct in signalling that there's not much to worry about in today's elevated stock prices, it adds to a growing body of thought that says stock prices could remain elevated for a long, long time.
Why wouldn't they? With bond yields so low and a global economy that is growing at a reasonable pace, stocks are pretty much the only game in town. No matter what crazy things Mr. Trump or Mr. Putin may do next, there's no obvious place for investors to run to for refuge – at least not until interest rates and bond yields rise strongly.
The problem with this rosy outlook for equities is that higher prices imply lower future returns. Stocks trading at 23 times earnings – a typical valuation in today's market – can't deliver the same payoffs as stocks trading at less than 17 times earnings, which is where the market has historically floated. Everything else being equal, today's stocks are priced to provide returns about a third less than the 6.7-per-cent-a-year real, or after-inflation, return produced by Wall Street over the past century. At today's stock levels, a 4.5-per-cent real return would seem reasonable and perhaps even optimistic.
Combine that with bonds, which at today's prices offer no real return at all, and a standard portfolio composed of 60-per-cent stocks and 40-per-cent bonds is primed to produce a real return of only 2.7 per cent a year – and that is before you pay taxes and fees.
Such paltry returns are considerably less than most investors expect and are well short of the returns most pension funds count on.
They would spell trouble for anyone saving for retirement or in retirement.
By comparison, a stock market decline of 15 per cent to 20 per cent might actually be welcome. It would position prices at levels far closer to normal valuations and it would create the conditions for stronger returns ahead.
As Ben Inker of money managers GMO has noted, investors face a tough choice these days. They can wish for the hell of continued high stock prices and the lower returns they imply, or they can hope for a market crash that might be painful in the short run but would at least open the door to stronger returns ahead.
Given that it's not clear which is the better option, perhaps investors' growing complacency isn't such a big mystery after all.
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Ian McGugan