Stocks: 1 Number That Doesn't Add Up


Stocks were near unchanged today, with the DowJones Industrial Average down 0.17% and the broader S&P 500 Index up just 0.02%.

Stocks: One number that doesn't add up
The VIX closed at 13.42 today, marginally above its 13.36 closing value last Friday, which was a five-and-a-half-year low. (The VIX is derived from S&P 500 option prices and measures investors' expectations for stock market volatility over the next 30 days.)

Historical. Implied. Cross-asset. Wherever you look, volatility is nowhere to be found!

Under most circumstances, the VIX largely reflects observed historical volatility in stock prices, as investors extrapolate the recent past into the near-term future. In that regard, the current multiyear lows in the VIX are consistent with recent market experience. As finance blogger Eddy Elfenbein remarked here, there's been an "average daily swing [in the S&P 500] over the last four days of just 0.085%" and added, "That's the lowest in more than seven years."

I calculated the S&P 500's historical volatility over a trailing period of 21 trading days (which is equivalent to a one-month period, on average.) As of today's market close, that figure is 14% -- a number that's consistent with the VIX. However, I noted with some discomfort that historical volatility was at almost exactly the same value -- 14.1% -- at the start of the second half of 2007, the period during which the credit crisis was began to roil markets.

The comparison doesn't imply that we're necessarily headed for a massive correction, but it highlights that low implied volatility typically rests on the assumption that a benign environment will continue on into the near future. Conversely, it rules out a volatility regime shift, a major reversal in sentiment, or a shock to the economy or the financial markets. I don't expect lawmakers to let the U.S. default on its obligations, but I can't rule it out with total certainty. It's a low-probability outcome that would certainly upend the markets and probably catapult the VIX to a record high.

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Fool contributor Alex Dumortier, CFA, has no position in any stocks mentioned; you can follow him on Twitter, @longrunreturns. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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