Volatility Across Asset Classes Raises Giant Red Flag

Stock market volatility, as measured by the CBOE Volatility Index (VIX), has surged in recent weeks, but price swings in other asset classes such as oil, bonds, and currencies also have become more pronounced, a warning sign for the broader market. “That becomes a risk that equity volatility is going to move even further,” Stuart Kaiser, head of equity derivatives research at UBS Group AG, told the The Wall Street Journal in a detailed story.

These concerns were voiced as the major U.S. stock indexes plunged about 3% on Wednesday, continuing their decline from their all-time highs in July, on concerns of a looming global economic slowdown.

Meanwhile, the low volatility stocks in the S&P 500 Low Volatility Index have been beating the full S&P 500 Index (SPX) by a wide margin, per Barron's. The respective gains over the past 12 months through Aug. 13, 2019 are 14.6% and 3.7%, per S&P Dow Jones Indices.

Significance For Investors

The Merrill Lynch Move Index, a measure of price volatility in government bonds, is up by about 43% for the month through Aug. 9, according to data from FactSet Research Systems reported by the Journal. Oil market volatility, as measured by the CBOE Crude Oil ETF Volatility Index, also has risen this month.

Currency volatility, as measured by the CBOE/CBE FX Yen Volatility Index, also is up in August, recently reaching it highest level since January. Additionally, the value of the Chinese yuan relative to the U.S. dollar has seen increased fluctuations recently, which may be a warning sign for U.S. stocks.

According to Mandy Xu, an equity derivatives strategist at Credit Suisse, the last time swings in the yuan-dollar pair were this high was on Aug. 11, 2015, prior to a global selloff in stocks, per the Journal. Based on closing prices, the S&P 500 endured a correction of 11.2% from Aug. 10 to Aug. 25, 2015.

Low Volatility Stocks

Regarding low volatility stocks, investors fleeing to safety have bid up their valuations, making them potentially risky bets right now. “It’s a scary trade because of the valuation,” Scott Opsal, director of research at The Leuthold Group, told Barron’s. “But people today want to own stocks because bonds are uninteresting, so they’re buying the chicken bets, which are low-volatility stocks,” he added.

Specifically, Opsal notes that low volatility stocks are trading at a valuation almost three standard deviations above their average valuation since 1990, making them more expensive now than they have been 99% of the time in that time period. However, since these stocks tend to offer attractive dividend yields and stable earnings that support the maintenance of those payouts, they “are geared to win in a falling-rate environment."

Utilities, REITs and insurance companies constitute about 50% of the S&P 500 Low-Volatility Index, Barron's observes. “Low-vol stocks are fully priced, but they offer two things that people want today: yield and safety if things go into the dumper,” Opsal said. Despite his concerns about valuations, he added, “I didn’t put a sell on low-vol because it has too many things going for it.”

Looking Ahead

“The biggest driver of financial markets right now is the trade tensions,” Brian McMahon, chief investment officer (CIO) of Thornburg Investment Management, told the Journal. “People aren’t sure which way to turn,” he added. With no resolution in sight for the U.S.-China trade conflict, increased volatility and a continued flight to low-vol defensive stocks are likely to continue.