Why Market Volatility Is in Secular Decline and How to Adjust to It

VIX and other “fear index” measures of market volatility are in secular decline. Markets are driven less by human emotion and more by automated trading programs and data dependent monetary policy than they used to be. These forces are proven volatility crushers.

Automated trading programs (AT, HFT, robots, etc.) dominate trading volumes in nearly all public, liquidly traded financial markets. Morgan Stanley estimated up to 84% of all orders placed on US stock exchanges originate from automated trading programs. Aite Group LLC, a Boston-based consulting group that analyzed Bank of International Settlements (BIS) data on spot foreign exchange dealing, estimates 81% of FX trading will be automated by next year.

By design, automated trading is designed to remove the weakest link in trading performance: human emotion. That means these programs are less likely to produce an outsized emotional reaction to incoming market data and are more likely to engage in the type of “range crunching” strategies that strangle volatility.

Humans are prone to overestimating the importance of each data point, whereas robots merely attempt to assign a statistically significant weighting. Let’s face it–most of the data points hitting markets each day are just noise. Only a few items really matter. One Global Dairy Trade auction probably shouldn’t move the New Zealand dollar by 2% in a rational market, though any trader loves to see irrational volatility they can seize upon. Automated trading programs are typically designed to fade overreactions rather than pile into them.

Additionally, monetary policy in the post Great Financial Crisis (GFC) era increasingly aims to lower market volatility. It does this by reacting to sizable asset price moves with counter actions–when equities fall sharply on fear, in comes your friendly neighborhood central banker hinting at fresh stimulus to stop the bleeding via monetary policy loosening channels. When risk markets are melting up, it is just a matter of time before a slightly less dovish central banker attempts to sprinkle in a shred of reality with hints of higher interest rates down the road.

Even during a potential future crisis, VIX will probably be muted somewhat compared to where it would have been in a similar magnitude of crisis had it occurred years ago. This is not a cyclical phenomenon; it is secular and structural. You need to accept this as a trader and adjust to it rather than thinking you identified a temporary anomaly of markets underpricing risk as most financial publications have erroneously suggested.

How should traders adjust to the “new world order” of low vol? First, stop chasing momentum. Trend following momentum strategies are not worth risking one’s capital unless the VIX (or comparable vol index) is above 20. Second, lengthen your holding time frame. Trying to rapid fire market orders in a “watching paint dry” market is a good way to chop yourself right into the margin call poor house. Finally, and most importantly, financial assets can trade at seemingly grossly overpriced valuation levels longer than you can stay solvent shorting “expensive markets.” That is because the volatility risk premium is diminished when VIX is crawling on the floor around a 10 handle. Lower volatility means higher asset prices, all else equal.

Bottom Line: Traders and investors should expect volatility to remain below historic norms. Central banks are long past a day where they will or even can allow true price discovery by fully letting the air out of the asset bubbles they created. That, along with increased trading automation and counter cyclical  monetary policy could allow elevated asset prices with low volatility to persist for much longer than many analysts estimate.