To sell implied volatility at current levels, investors must imagine tomorrow will be virtually identical to today. They must imagine that bond yields won’t rise despite every major central bank looking to hike interest rates and exit QE. They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by decelerating global growth. And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure. I can imagine a few of those things happening, but neither sustainably nor simultaneously. It is much easier to imagine a tomorrow that looks different from today.

As volatility declined, investors have had to sell even more of it to sustain sufficient profits. This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices. This in turn reduces volatility, reflexively. Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, I can imagine a historic reversal.

And at that point, investor imaginations will run rampant with visions of cataclysms. It is always thus, it is who we are. Confidence in a tomorrow that is indistinguishable from today will vanish, replaced by some new hysteria. It could be real or imagined. It could even be a bullish blow-off mania like 1999. Or maybe an endogenous crash, like 1987, when market moves were disconnected from the real economy. But the catalyst doesn’t really matter. What matters is recognizing that at this late stage, with implied volatility where it is, and asset valuations where they are, if you can imagine a tomorrow even modestly different from today, you must begin finding thoughtful ways to get long volatility

U.S. equity market volatility (vol) has been plumbing lows, stirring concern that a spike is overdue. We believe low realized vol can last for years, even with sporadic bursts, and it tends to overlap with periods of subdued macroeconomic vol.

Chart of the week
Realized U.S. equity volatility, 1872-2017

We dug into data on U.S. equity market vol spanning more than a century to better understand its patterns. The chart shows realized (i.e., historical) volatility does not settle around a long-term average. Instead it is often low for long and sometimes high. We see regimes as a better framework for understanding vol versus expecting it to return to a “normal” level. History shows low vol regimes can last a long time.

What triggers a switch?

Low stock market vol only seems to keep getting lower. Yet we believe there are good reasons for vol to be subdued, as we write in our new Global macro outlook Learning to live with low vol. Looking back, we find low-vol regimes, when U.S. equity volatility averages 10%, can last for years. That means realized U.S. equity vol has historically stayed low for remarkably long periods of time. Sporadic spikes in volatility can occur but without causing a prolonged shift to a high-vol regime (22%, on average).

What triggers a switch? The economy is key. Jumps to high-vol market regimes tend to coincide with rising economic vol. Since 1985, U.S. equity and economic vol regimes have overlapped, apart from the 1987 equity plunge and 1998 market seizures. Those episodes were short-lived and did not feature high macro vol. What drives economic vol, or volatility in gross domestic product (GDP) growth? It tends to be low in expansions, but surge around recessions. We see the current U.S.-led expansion lasting years.

Low vol by itself does not equate to complacency, in our view. The key question is whether it spurs build-ups of systemic vulnerabilities. We do not see systemic risk as high but are on watch for any stealth leverage build-up. The popularity of leveraged equity vol selling as a strategy to generate income may help suppress the VIX, a measure of expected vol for the S&P 500 that hit an all-time low in July. It could also lead to sharper unwinds. More broadly, we are seeing risks in pockets of credit but not in the broader market. We believe post-crisis financial regulation and periodic bursts of anxiety have kept asset froth in check. Combined with our view that the U.S. cycle has room to run, we believe this environment helps foster risk-taking.