A Deeper Dive - The Fear Index
In our new format each quarter, we will take a little deeper dive into a topic that is timely and interesting. We’re certainly open to suggestions on topics that you’d like to understand better or hear more about (email us here), but this quarter, we thought we’d devote time to something that the industry and media refers to as the “Fear Index”. It gets a lot of attention during market panics, but has recently garnered more mentions due to the fact that investing “fear” is at historic lows.
The “Fear Index” is also known as the VIX index or Volatility Index and is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option pricing. That is obviously a mouthful and the calculation of the actual index level is not for the mathematically challenged. What it all boils down to is an attempt at quantifying the general mood or frame of mind of investors. Fortunately grasping the meaning of the index level is much more intuitive than the actual calculation – the higher the number the higher the expected level of volatility and the greater the fear, the lower the number the lower the level of expected volatility and fear.
We chose to write about VIX as our first “Deeper Dive” partly due to the media attention it has received more recently as it continues to sit at record low levels. As the following graph shows the VIX is currently well below its long term average of 20 (green line) with a reading of around 10 which has historically acted as an unofficial, arbitrary lower limit.
What does all this mean? If spikes in the VIX indicate fear and panic, then historically low readings must indicate a lack of both or a general feeling of complacency and comfort. The recent drop in the VIX indicates investors are not just unworried by the myriad of geopolitical concerns and high valuations, but their level of comfort is at unprecedented levels. While relatively low volatility levels existed for nearly a continuous 3 year period from 2004 through early 2007 what we are witnessing today is really extraordinary. From the beginning of 2003 through quarter end the VIX had closed below 10 only 9 times (out of 3,764 trading days). An amazing 7 of those 9 times have occurred just this quarter (actually since May 5th)!
Our purpose in discussing the VIX and its current level is certainly not to scare anyone and suggest a selloff is imminent. It is absolutely a note of caution, however, and a reminder that what we are experiencing is neither normal nor likely to last forever. We don’t know what the trigger will be or how long it will last, but the probabilities certainly point to volatility picking up. Rather than assume we are in a new normal, it is better to prepare ourselves and our portfolios. As we’ve discussed with each of our clients over the last few quarters it is why we remain committed to the use of alternatives and have shifted equity exposure to more attractively valued parts of the globe.
Anytime the VIX reaches historic lows or highs, I’m reminded of one of Warren Buffett’s more famous quotes:
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Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.