By Joe Mallen and Chris Shuba of Helios Quantitative Research
The other day I was telling my daughter the story of the boy who cried wolf. As the story goes, a little boy would keep fooling the villagers that a wolf was stalking their herd of sheep… until one day a real wolf came along and no one believed the boy’s cries for help. I’m pretty sure the story ended poorly for the little boy. That story reminds me a bit of today’s equity marketplace.
It seems most investors over the years have simply become desensitized to the volume of squawking news headlines. In more recent days, despite economic policy stories that usually cause market trepidation – such as healthcare reform (or lack thereof), the debt ceiling debate, and short term interest rate hikes to name a few – the US equity market has trended to very low levels of volatility. So, why do some investors say this environment feels so volatile, but traditional measures of volatility remain historically low?
An interesting measure of this “feeling” or general atmosphere is the Baker, Bloom and Davis news-based index of economic policy uncertainty for the US. The index is based on the frequency of newspaper references to policy uncertainty. Likewise, a commonly used gauge of US equity market volatility and investor sentiment is the VIX index. The VIX measures the implied volatility of the S&P 500 in the near term as derived by the market participants in the 30-day options market.
As one would expect, the two indices have historically exhibited high correlation to one another. As headlines detail uncertain policy, the markets tend to translate that information into implied market volatility. Chart 1 shows the historical relationship between the two.
Source: Bloomberg, Helios Quantitative Research
Starting in 2010, the relationship and reasoning breaks down. In Chart 2, the ratio between the two has dislocated and is now near an all-time high. This ratio peaked immediately following the election in November 2016. The last time this measure was as high, it preceded a very strong equity market from 2012-2014.
Source: Bloomberg, Helios Quantitative Research
As we navigate expectations in an environment of heightened headline risk and subdued volatility, it is critical to focus on the data that moves markets. This is an important chart to share with clients, as it will help show why making investment decisions solely based on news headlines is a terrible idea. We feel strongly that the more reliable source is the active market participants with money at risk, not the sources whose job is to sell newspapers.
More importantly, the vast amount of news and information at our fingertips has created an environment where markets do not react the same way as they used to regarding policy related information that can signal rough economic times ahead. So, what happens when the wolf finally comes along to feast on our herd of sheep?
With all the “fake news” out there and escalating distrust in the accuracy of traditional media, we must consider the fact that once real danger comes along, Advisors will have to rely on sources other than the traditional relationship between news and risk. This is a period of time where we feel a deep, quantitative approach to investing has the chance to help Advisors deliver quality advice to their clients. By using real-time data focused on what is really happening within the economy and markets, we believe this is the most prudent and accurate way to help clients avoid the next recessionary environment without crying wolf.
This article was written by Joe Mallen and Chris Shuba of Helios Quantitative Research, a participant in the ETF Strategist Channel.
Helios Quantitative Research provides financial advisors with the ability to offer state-of-the art, algorithm-driven asset management solutions to their clients on any platform. This allows advisors to:
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