World Class Faculty & Research / May 10, 2017

Wall Street's 'Fear Gauge' Is at a 23-Year Low. Should We Worry?

SMITH BRAIN TRUST – Leave it to a period of calm to inject nervousness into the market, as it did this week when the Chicago Board Options Exchange's Volatility Index, or VIX as it is known, dropped to a level not seen in about 23 years. The drift lower in the so-called fear index has market watchers worriedly speculating about a calm before a storm.

After all, financial markets are full of patterns, and the VIX's downward swing had some market participants recalling its dip in 2007, shortly before the subprime mortgage crisis.

But Steve Heston, professor of finance at the University of Maryland's Robert H. Smith School of Business, says he sees little to fear in the fear index.

"It might be that VIX is fairly priced for the first time – and that risk is fairly low," says Heston, who developed one of Wall Street's most widely used Stochastic Volatility models. His statistical method in mathematical finance is used to evaluate derivative assets, such as options.

The VIX is a gauge of expectations for future stock market gyrations, based on prices in the options market. It represents the price the market is willing to pay to insure a portfolio against volatility over the next month, or three months.

Historically, VIX options have been overpriced, Heston says, and selling the VIX has been profitable. With the surging popularity of exchange-traded funds (ETFs), there have been more sellers and fewer buyers for the VIX, driving its prices lower.

"So either options have gotten cheap because they should be cheap, because the market is not moving much lately, and it's not expected to move, or it's gotten cheap because people are not willing to pay as much for options, because they realize they've been historically overpriced," Heston says.

Since November, the S&P 500 Index has steadily grinded higher, without any meaningful pullbacks, says Kristen Fanarakis, assistant director of the Center for Financial Policy at the Smith School. The VIX has drifted lower over the same period, with few major risk events stalling a stock rally that she says has been driven by better earnings and a more optimistic outlook on the economy.

There hasn't been a recent major terrorist attack, Heston adds, and "despite his tough talk," Trump has been "cautiously isolationist" in foreign policy. Trump's one big trade negotiation so far has been on Canadian softwood lumber, a relatively minor matter that's unlikely to roil the economy. "It looks like we will have political gridlock, along with some back-and-forth on health insurance policy," Heston says. But with the U.S. economy generally on firmer footing, that's not likely to rattle investors or drive volatility.

Still, some people see the dip in the VIX as a signal that investors "have become far too complacent, which can be equally worrisome," Fanarakis says. "There aren't any other major risk events on the calendar near term, but as we learned in 2007 when volatility was also quite low the risks aren't always obvious."

Volatility is mean-reverting, Heston adds, suggesting it will gravitate back toward its historical mean or average. "I can almost guarantee that the VIX will rise when the market falls. And I can guarantee the market will eventually fall."

If there's one thing investors know, it's that nothing travels in a straight line. The stock market cannot keep hitting new highs forever.

"There will be more terrorism. There will be economic issues. The Fed will raise interest rates – or if they don't raise interest rates, it will be for some reason," Heston says. "Things will happen."



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About the University of Maryland's Robert H. Smith School of Business

The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and flex MBA, executive MBA, online MBA, business master’s, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.

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