Volatility's warning

Footsie's strong rise so far this year has led to concerns that shares might have become overbought. From an economist's point of view, the issue here is: is there predictability in returns?

For shortish-term returns, the most promising indicator is the Vix index, a measure of the implied volatility on S&P 500 options. This is commonly called the 'fear gauge', and basic economics tells us that lots of fear should imply high expected returns.

Which immediately draws attention to a problem. The Vix now, at 12.7 per cent, is close to its lowest level since the spring of 2007. This suggests investors might have become too complacent, and so the market might be heading for a fall.

We can quantify this. The relationship between the Vix and the subsequent five-week change in the All-Share index since March 2009 points to the market falling around 1.2 per cent in the next five weeks, with a 60 per cent chance of some kind of fall.

However, the link between the Vix and returns is not stable. In bull markets, the trade-off between volatility and subsequent returns is better than it is in bear markets. My table show this. It shows that, in the bear markets of 2000-03 and 2007-08, a Vix as low as we have now led to big falls in the subsequent month, whereas in the bull market of 2003-07, it led to a rise in prices.

(You might object here that our R-squareds suggest there isn't much predictability from the Vix. But this is only to be expected in a market dominated by noise; the difference between regression-based and judgment-based forecasts isn't that the latter have larger R-squareds, but that they don't even bother to measure or report them.)

This poses the question: could it be that today's low volatility is a sign not that investors are complacent, but rather that the volatility-return trade-off is improving?

I doubt it, for two reasons.

First, bull markets usually occur when the world economy is growing nicely. This is not the case now. This doesn't mean shares can't rise. It just means any rise would take the form either of a further reduction in perceived risk, or of increased bets on an economic upturn later in the year.

Secondly, a Vix of 12.7 is low even by bull market standards. If we assume market conditions have returned to the 2003-07 average, a Vix as low as we have now points to a return of less than 1 per cent in the next five weeks, with a 37 per cent chance of some kind of fall.

To be a short-term bull from here thus requires you to think that we're in a better bull market than we had - on average - between 2003 and 2007. This is possible - given that the market is noisy and so we could get lucky. Personally, though, I'd rather not bet on it.

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