Russ Koesterich: When you’re watching horror movies, the time to worry is when things become eerily quiet. Last Friday, the market’s own measure of fear, the Chicago Board Options Exchange Volatility Index (VIX), hit its lowest level since last July. This is the financial equivalent of eerily quiet.
The VIX tracks the implied volatility on S&P 500 options. When investors are nervous, they’re more likely to purchase put protection, driving up the cost of options and implied volatility in the process. When markets are calm, or investors are too complacent depending on your point of view, the VIX tends to sink back into the teens.
At its current levels around 17 and 18, the VIX is modestly below its long-term average of 20 and is well below its 2011 peak of nearly 50. It’s also below the mid 30s it hit in October, when I argued that the VIX was too high and would likely moderate towards the high 20s or low 30s.
But while the VIX should certainly be lower now than it was six months ago, I believe its current levels seem too low. While market conditions have certainly improved since the fall, it looks like investors may have become a bit too at ease. With the risks to Europe lingering and most of the world still stuck in a lackluster recovery, a bit more caution — or fear — may be warranted.
Historically, economic activity, credit conditions and market momentum are three key drivers of implied volatility. All three have improved in recent months. Leading indicators have risen, market momentum has improved and credit spreads – measured by the spread between the 10-year note and an index of high yield bonds – have contracted by around 1%. Thanks to the improved general market environment, the VIX should certainly be lower than my October forecasts. However, in my opinion, a fair current value for the VIX would be around the low to mid 20s, higher than today’s levels. And unless we see a further acceleration in the economy and more spread tightening, I would expect volatility to post a modest rise in the coming months.
So assuming that volatility is set to rise, how should investors adjust their portfolios? First, remember that it’s the change in, not the level of, volatility that tends to impact asset prices. In an environment of rising volatility, investors would want to modestly lower their weight to market segments that are very sensitive to changes in volatility and raise their weight to less sensitive or lower beta instruments.
Practically, this could mean a modest reallocation out of high-yield fixed income towards investment-grade bonds, an asset class that currently appears to be a better relative value [potential iShares solution: iShares iBoxx $ Investment Grade Fund (NYSEArca:LQD)]. While the spread between high yield and Treasuries has contracted by roughly 200 basis points since September, the spread between Baa bonds and Treasuries has been stuck at approximately 325 bps. Investors may also want to consider modestly increasing their weight to mega-cap equities. This segment of the market still trades at a significant discount to the broader market and is less sensitive than other segments to changes in volatility [potential iShares solutions: iShares S&P 100 Index Fund (NYSEArca:OEF), iShares S&P Global 100 Index Fund (NYSEArca:IOO), iShares Dow Jones EPAC Select Dividend Fund (NYSEArca:IDV), iShares High Dividend Equity Fund (NYSEArca:HDV)].
Bonds and bond funds will decrease in value as interest rates rise
Written By Russ Koesterich From The iShares Blog Disclosure: Author is long LQD
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist as well as the Global Head of Investment Strategy for BlackRock Scientific Active Equities. Russ initially joined the firm (originally Barclays Global Investors) in 2005 as a Senior Portfolio Manager in the US Market Neutral Group. Prior to joining BGI, Russ managed several research groups focused on quantitative and top down strategy. Russ began his career at Instinet in New York, where he occupied several positions in research, including Director of Investment Strategy for both US and European research. In addition, Russ served as Chief North American Strategist for State Street Bank in Boston.
Russ holds a JD from Boston College Law School, an MBA from Columbia Business School, and is a holder of the CFA designation. He is also a frequent contributor to the Wall Street Journal, New York Times, Associated Press, as well as CNBC and Bloomberg Television. In 2008, Russ published “The ETF Strategist”(Portfolio Books) focusing on using exchange traded funds to manage risk and return within a portfolio.