May 4, 2017 / 7:40 PM / 6 months ago

Volatility near record lows a bad omen for stock returns

NEW YORK (Reuters) - U.S. stock market volatility is close to record lows and, going by history, that does not bode well for stock market returns over the next twelve months.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S., May 4, 2017. REUTERS/Brendan McDermid

The CBOE Volatility Index, better known as the VIX and the most widely followed barometer of expected near-term stock market volatility, this week fell to its lowest level since February 2007.

Since the VIX generally moves inversely to stocks, a low VIX typically indicates a bullish outlook for stocks, but the lows the index has touched are sounding caution for stock investors.

Past instances of VIX lows suggest that the next 12 months could be a lot more challenging for stocks than the year that preceded the trough.

The S&P 500 Index has risen about 16 percent over the past year. Stocks’ relentless climb in the face of risky events, including Britain’s vote to exit the European Union and the U.S. election, have crushed volatility.

The end of April marked the quietest 4-month period for U.S. stocks in over two decades.

“People should look at this low VIX as a market signal to lighten up on aggressive positions,” said Michael Purves, chief global strategist at Weeden & Co in New York.

The VIX briefly slipped to single digits this week and twice in the last two weeks closed below the 10.50 mark.

Since its inception in 1990, the VIX has closed below the 10.50 mark only on 46 days, with these lows clustered around December 1993, December 1995, July 2005, December 2005, November 2006-Feb 2007 and July 2014.

Barring the December 2005 episode, the 1-year returns after these VIX lows lagged returns for the 1-year S&P 500 headed into the low volatility period, a Reuters analysis showed.

The VIX has logged big spikes over 1-year periods following the troughs, sometimes even doubling, albeit from very anemic levels.

For example, the S&P 500 index had gained about 13.7 percent, over the previous 52-weeks on Jan 24, 2007, when the VIX fell to 9.89. A year from then, the &P 500 was down 6.12 percent.

Even in cases where the index has avoided logging a loss one year after a VIX low, the returns have been a shadow of gains notched up in the year headed into the volatility trough.

“It means expectations for returns based on prior similar experiences over the next year are lowered,” said Scott Maidel, director at Gladius Capital Management in Chicago.

Maidel, however, warned that this is not a signal that investors need react to aggressively.

Low volatility periods usually end gradually, rather than in a sudden explosion of volatility. While there are plenty of near-term catalysts that can upset the volatility cart, this abnormally low volatility could very well persist, particularly through the summer, analysts said.

Still, those looking to profit from a rebound in volatility can do so by selling VIX puts to buy VIX calls, Weeden’s Purves said.

(For a graphic on the history of volatility troughs and 1-year S&P 500 Index price returns, click reut.rs/2p23zem)

Reporting by Saqib Iqbal Ahmed; Editing by Nick Zieminski

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