Two things have marked 2013 as an extraordinary year for U.S. stocks: big gains and an exceptionally smooth ride. Recently investors have been worried about the former, i.e. is the market in a bubble. In my opinion, the bigger risk, at least in the near term is the latter: low volatility.

Year-to-date, market volatility (measured using implied volatility based on the VIX) is around 14, compared to historical average of around 19. More recently the VIX Index has dropped as low as 12, approaching the multi-year lows seen in March and August.

To be sure, at least some of the drop in volatility is probably justified. In the past, market volatility has typically been driven by a number of factors: past volatility, market momentum, and credit market conditions. Most of these factors suggest that equity market volatility should be somewhat lower than normal:

  1. Market momentum has been exceptionally strong this year. By the end of October, the 12-month trailing gain for the S&P 500 was 25%.
  2. Low equity market volatility is normally associated with easy credit market conditions. As spreads get tighter, indicating easier credit market conditions, volatility typically declines. The 20-year correlation between the VIX and high yield spreads is nearly 80%. As the chart below shows, a rough rule of thumb is that for every 100 basis point (bps) tightening in high yield spreads, the VIX typically drops by around 2.5 bps.

Source: Bloomberg

 

The problem today is that even after accounting for strong momentum and benign credit conditions, volatility looks unjustifiably low. In addition, there are other, less benign factors that investors may be ignoring.

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