Expert's View 名家觀點


七月 1 , 2017  

Are Markets Too Complacent?


by Charles Cheng, CFA
鄭又銓, CFA



In our previous letter, we discussed how we are probably yet not close to the end of the current economic upcycle. Financial markets seemingly have also taken this view into account, with a sustained uptrend and little day to day movement, and taking the recent Fed rate hike in stride. However, have markets become too complacent, considering that risks, both economic and political, remain beneath the surface?




On June 2nd, the VIX index, which measures implied volatility of US index options, closed at 9.75, its lowest level ever (using the current calculation method). In non-technical terms, the index is a measure of how much traders are willing to pay for insurance against sudden market movements. When the market is calm and not much turmoil is expected on the horizon, the price of this insurance and therefore the index will drift lower.



Source: CBOE


Therefore, it has become an unofficial measure of how complacent that market participants have become. Historically, the index has suddenly spiked during and following market corrections and crises. Often, before those events, it would have trended down for extended periods, as is the current case.



Source: CBOE


Of course, this is just one indicator of market sentiment among many. But we can go back to the historical record to see if it would have been a helpful warning sign in the past. On the most current index, the VIX has only ever closed below 10 within the most recent month or two, and has closed below 11 in Jul 2005, Dec2005, Mar 2006, Oct 2006- Feb 2007, and the recent period of Apr-Jun 2017.



Source: CBOE


Looking at the above periods, it may be slightly worrying that the last sustained period of a VIX this low was the year that the global financial crisis started. However, the market actually peaked months later in October 2007 and after VIX had risen as high as 30 in preceding weeks and months. For the earlier pre-2004 period, there were times where low expected volatility periods were followed by eventual corrections and others where there were not.




Ultimately, indicators like these should be treated as part of the overall picture, not a driver of market risk in of itself. A low implied volatility index, other than showing that the cost of insuring your portfolio against a drop may be cheap at the moment, can also hint at other underlying factors. For example, there is leverage built into the portfolios of speculators and banks following such a period of relative calm, or there could be risks that the market simply is not pricing in at the moment. If most speculators feel that nothing will move the market in the near term, then any unexpected event could cause them to scramble to unwind their positions, leading to a sudden correction in the market. At the moment, there is little sign of a major crisis happening in the near term, but it would be wise not to ramp up the risk taking in your own portfolio.




Mr. Cheng is a managing partner at a Hong Kong based independent private investment office that directly manages personal accounts for families and institutions.