A couple of notable statistics pertaining to current market conditions are VIX and implied volatility numbers for the S&P 500 and other major market indexes.  For those who are not familiar with these measures, they are ways to quantify risk.  Implied volatility is the market’s consensus view of risk.  VIX is an index that tracks very near-term implied volatility.  There is a great deal that we can see in the market by looking at these numbers.

The trailing 3-month volatility of SPY (an S&P 500 ETF) is below 12% and VIX is at 16.3 (16.3%) as I write this.  The trailing 1-year volatility for SPY is 22.7%.  Market volatility in the last several months has been very low.

Now let’s look forward.

There are several major market indexes that are worth watching.  SPY, which tracks the S&P 500, is a key index on which to watch implied volatility.  Implied volatility on EFA, an ETF which tracks the EAFE index, gives us a measure of risk in Europe and other developed markets.  Another important indicator is implied on ETFs on high-yield bond ETFs such as HYG and JNK.  I see high-yield bonds as especially important because the risk in high-yield is mainly from the possibility of default (e.g. companies failing to pay their bondholders).  Default is quite different from market risk, the primary source of risk in a stock index such as the S&P 500.  Specifically, implied volatility on a high-yield bond ETF shows us the market’s expectation of defaults as opposed to the market’s uncertainties about future earnings, which are reflected in implied volatility on stock prices.  Specifically, if we see high implied volatility for stocks but modest implied volatility for high-yield bonds, this suggests substantial potential for bad news or economic stagnation.  If we see high implied volatility for high-yield bonds, the market is suggesting such bad conditions that companies have an elevated probability of real failure.

In the table below, I show recent trailing volatility for these three asset classes, along with implied volatility for options expiring in December 2012 (SPY, EFA) and January 2013 (HYG).  It would be preferable if the options all expired in the same month, but there are no traded options on JNK for December, so January 2013 is the closest we can get.

Trailing volatility vs. implied volatility (Source: Morningstar).

Trailing volatility vs. implied volatility (Source: Morningstar).

These data show that the volatility in all three of these asset classes has been very low over the last three months.  Both the trailing 1-year volatility and the implied volatility for options expiring at the end of this year and the start of 2013 are much higher than the recent 3-month volatility.

The good news is the implied volatility on high-yield bonds looks quite modest, albeit considerably higher than we have seen in recent months.

The last time implied volatility vs. trailing volatility looked like they look today was in Spring of 2007.  Back then, VIX and recent trailing volatility was low but implied volatility was much higher than recent years’ trailing volatility.

Historical VIX (Source: Yahoo! Finance).

Historical VIX (Source: Yahoo! Finance).

In February of 2007 (marked with a dot), VIX was at 15.4.  The chart above tells the story.  By late 2008, VIX had risen by around 400% to 60.

Measuring investment risk using implied volatility is somewhat similar to measuring hurricane risk at a beach house based on the cost of homeowner’s insurance.  In both cases, you are using the prices at which someone will sell you insurance against ‘bad outcomes.’  In the case of implied volatility, you are looking at buying put options on a stock index such as the S&P 500.  These put options act as insurance, paying you if the index declines.  Implied volatility increases as the prices of these put options go up (and vice versa).  We are asserting that the cost of insurance is a decent measure of risk.

The trailing historical volatility and implied volatility for major domestic and international stocks, as well as for high-yield bonds lead me to one of two possible conclusions.  Either market risk and default risk have really dropped in recent months and the options markets have not gotten the memo or the options markets are correctly signaling that the current period of soaring prices is not sustainable and the markets are being somewhat complacent.

Disclaimer

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services.