Idea of the Day Indices and low volatility

What: The Vix volatility index has been hovering near its lowest levels since 1993 for most of this year, it is currently trading around 10.50, a historically low level, suggesting that all is calm in the markets and price movement in subdued.

There are two things to say about this: firstly, this is very typical at this stage of a stock market rally – when stocks have made record highs volatility can fall as investors get worried about buying at the top of a bull market. Secondly, volatility doesn’t usually stay this low forever, however, it can do so for protracted periods, so you need to ensure that you are prepared for a low volatility environment.

How: We believe that relative value trades are an idea worth considering in a low volatility environment. The chart below shows the S&P 500, the Dax, Eurostoxx, Cac and FTSE 100, this chart has been normalised to show how they move together. This chart can tell us some interesting things about global indices, including:

• All global indices have been moving in the same direction (upwards) for most of the last 12 months.
• The Dax is the best performer out of its peers, after it overtook the FTSE 100 in March, as political risk in the currency bloc receded.
• The pace of gains in the S&P 500 has started to lag since mid-March, although this index has continued to trend higher and has made fresh record highs during this time.
• The Cac, Eurostoxx index and the FTSE 100 have been following each other very closely since mid-May, and have started to back away from recent highs after a recent spate of losses for these indices.

Ideas from this analysis:

• Relative value analysis would suggest that the outperformer- the Dax – is vulnerable to a weakening in performance, whereas the S&P 500 – the underperformer – could play catch up in the medium term. So, a short Dax vs. long S&P 500 trade could express this idea.
• The relative weakness in the Cac, Eurostoxx index and FTSE 100 should be watched closely. If these indices continue to decline then it may give an early signal that the bears are starting to take control and global indices could be at risk from a sell off thus pushing up volatility. .

To conclude, in a low volatility environment, it is worth considering a relative value strategy. Also, since global indices tend to move broadly in unison, signs of weakness in one or more indices can be a sign that a sell off is on the horizon and is worth watching closely.

Figure 1: 

Source: City Index and Bloomberg