Opportunity Risk High: Low VIX, low rates scaring equity investors away

As of 06-04-2014

A lot’s been written about the unexpected decline in 10-year Treasury yields and the market’s very low “fear gauge,” i.e., the CBOE Volatility Index, or VIX. Usually Treasuries rally when fear is rising, not falling. History also shows a low VIX can presage big corrections—the Wall Street Journal says 34 of the 50 lowest readings came in 2006 and 2007, just before a roaring bull went bust. Not surprisingly, bears have hopped on the “end is near’’ train, warning these somewhat countervailing trends suggest a market top is near and a big sell-off waits in the wings. Investors appear to agree, as monthly net flows into domestic equity mutual funds turned negative in May for the first time this year.


Opportunity risk is high as confusing signals have investors moving out of equities

The problem with this analysis is two-fold. One, the Treasury rally appears to have little to do with fear or fundamentals. While winter was a bear—borne out in the first-quarter contraction in GDP—virtually all the data since reflects accelerating growth, which should carry over to financial results and equity valuations. What drove Treasuries, it appears, are technical factors that don’t have much to do with fundamentals, including traders covering short positions because they thought rates would rise this year; a declining deficit that is cutting into the supply of Treasuries; and Treasuries’ attractiveness relative to their lower-yielding euro brethren. Rising demand/declining supply equals higher prices (and thus lower yields). There also have been numerous Fed pronouncements indicating a preference to keep rates lower for longer.

Secondly, the Wall Street Journal only got it half right. Yes, the VIX hung around near-record lows the two years before the late 2008 crash, but that’s the point. It was two years before the crash. A lot of money could be left on the table waiting for the big correction and a spike in the VIX. And this doesn’t even account for the argument that the economy, both at home and abroad, is a much different place than it was in the build-up to 2008’s global financial crisis—that once-in-a-century event was driven by the whole world levering up on unsustainable home prices. It’s hard to find any such excesses today, just as it’s difficult to ignore the much more aggressive stance being taken by central banks everywhere.

Add it all together and what we have is high opportunity risk, i.e., the opportunity to make money is being undermined by the fear of losing it. That’s good for those who stay calm and invested in equities; not so much for those who get out or never get in. The same ICI data that reflected last month’s net outflow in domestic equity mutual funds also captured a big net inflow into taxable bond funds. Perhaps Treasury yields will continue to fall, generating gains that barely keep up with inflation. But what if they don’t? And what if stocks keep rising? Are you OK with those potential (and from our perspective likely) outcomes? Managing risk includes managing opportunity. At times like this, investors need to navigate, not leave, the market.


 
 
 
 
 
 
 
 
 
 
 
Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.
Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.
Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.
VIX: The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility.
Federated Equity Management Co. of Pennsylvania
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Copyright © 2014 Federated Investors, Inc.

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