04 Feb 2013

If there is one graph that one might look at that would best summarize perceptions of risk associated with the world economy, which graph would that be? Probably the VIX-- a volatility index published by the Chicago Board Options Exchange (CBOE)—also known as the “fear index”. It is calculated based on the number of put and call options sold, as related to S&P 500 shares, with a 30 day duration. So a reading of 15 means that the market expects the S&P to go up or down by 15% (on an annualized basis) over the next 30 days.

As the chart below indicates, over recent decades, the VIX index was at its highest at the time of Black Monday in 1987; in recent years, the high point was around the collapse of Lehman Brothers. The chart below –relatively speaking—indicates how dramatically fear levels in financial markets have diminished in the recent past. Prima facie, this is very good news.

But should we breathe easily? Not completely. Ultimately the VIX index deals with perceptions. What if we are living in a fool’s paradise, where investors might be falsely oblivious to the risks around them? In such a case, the VIX index could provide a false sense of security. What might such risks be?

  • Risks associated with the US deficit/fiscal easing program, which might create anything from a collapse in the credit rating and prices of US Treasury bond prices to a major devaluation of the US Dollar. It will also be very interesting to see how financial markets react when the punch bowl of Quantitative Easing is taken away.
  • There are risks in the banking sector, associated with banks that are overly leveraged, with too thin an equity cushion, and perhaps doubtful loans, etc. not fully accounted for.
  • Chinese has occasionally sputtered in the recent past. Given that large parts of Chinese society believe that economic growth gives the Communist party legitimacy, a major slowdown growth could have major consequences.
  • The possibility of another war in the Middle East (North Korea perhaps less likely) should never be completely discounted. This may trigger other calamities (e.g. blockage of oil shipping through the Straits of Hormuz).
  • One or more natural disasters could be significant in themselves, or also trigger other chain reactions (a la Fukushima).
  • Another epidemic along the lines of H1N1 could tip the world back into recession.

The world of investing has never been a risk-free environment. The above list is not even exhaustive. The question, in my mind, is whether the above risks are fully priced into the current VIX. This ultimately leads into a debate about whether one believes in the efficiency of financial markets (what better indicator could there be than the decisions of the sum total of all investors?) to the belief that investors are like lemmings, flocking to the latest investment fashion where a quick buck can be made.

My personal view is that the above risks, the first two being the most formidable, are not fully priced into today’s markets. But that is only a personal view. I am the first to admit that I have no empirical evidence. (And I would suggest that anyone who claims to have empirical evidence should be challenged).

I draw two conclusions from the above:

First, that low risk perceptions provide Governments the world over with an opportunity to clean house—to bring deficit spending under control is the most important measure to be taken by the US Government and many others.

Second, that investors need to be cautious, taking care to diversify their portfolios among different asset classes, and have quality assets within each class.

In other words, VIX is a very important piece of data, but should not be relied upon blindly.