About this Episode
Less than two months ago, the S&P 500 and the Dow were riding to record highs after 11 years of unprecedented economic expansion. In the time since, the market has seen steep drops and slightly fewer steep rises. An oil price war and the global coronavirus pandemic have each contributed to historically high levels of volatility. Is a jittery market the new normal, or just a passing phase? In conversation with host Nathan Hunt, Craig Lazzara, Managing Director for Investment Strategy at S&P Dow Jones Indices, discusses record market volatility, the VIX, and Russian literature.
The Essential Podcast from S&P Global is dedicated to sharing essential intelligence with those working in and affected by financial markets. Host Nathan Hunt focuses on those issues of immediate importance to global financial markets – macroeconomic trends, the credit cycle, climate risk, energy transition, and global trade – in interviews with subject matter experts from around the world.
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Craig Lazzara: There's a saying in, well, I'm not particularly a student of Russian literature, but I do know that in the first line of Anna Karenina, Tolstoy says, "All happy families are alike; every unhappy family is unhappy in its own way." And bear markets are like unhappy families. They're all unhappy in their own way.
Nathan Hunt: This is the Essential Podcast from S&P Global. My name is Nathan Hunt. Less than two months ago, the S&P 500 and the Dow were riding to record highs after 11 years of unprecedented economic expansion. In the time since, the market has seen steep drops and slightly fewer steep rises. An oil price war and a global pandemic have each contributed to historically high levels of volatility. Is a jittery market, the new normal, or just a passing phase? I'm joined today by Craig Lazzara, Managing Director for Investment Strategy at S&P Dow Jones Indices. Craig, thank you for joining us.
Craig Lazzara: Thank you, Nathan. Delighted to be here.
Nathan Hunt: Craig, you work at S&P Dow Jones Indices, so your products and services are used by both passive and active equity investors. What does history tell us about the relationship between stock prices and equity price volatility?
Craig Lazzara: The relationship is in technical terms inverse, Nathan, meaning that when volatility is high, typically returns are low or negative, and typically when returns are attractive, volatility is below average. If you look at the history of the S&P 500, for example, and just divide up all the months in our database into above average and below average, or, I should say, above median or below median volatility months, in the below median months, the average return is in the range of about 1.8 to 2%. In the above median volatility months, the average return for the S&P 500 is slightly negative. So there's a, there's a clear negative relationship between returns and volatility.
Nathan Hunt: Why is there that negative relationship?
Craig Lazzara: I think the best way to understand it, and it does make sense, is to say that you remember that a, that a stock is ultimately valued at the present value of its future cash flows. If there's more uncertainty in the market, the discount rate applied to those cash flows goes up. And therefore the price of the asset comes down. Well, part of the discount rate that's applied to any stock's cash flows is a premium for volatility. If there's lots of uncertainty, you're going to discount at a higher rate than if there's very little uncertainty. So when uncertainty increases, volatility increases, the natural discount rate goes up, and the natural fair value of the equity market goes down. So I think that the logical connection, I think is simply that as investors are less certain of the future, they're inclined to pay less for it.
Nathan Hunt: What is the VIX?
Craig Lazzara: VIX is an indicator of market uncertainty. Normally when we measure volatility, even if there's a number of ways one can do it, the most conventional ones, certainly the completely functional one, is to simply look at the standard deviation of prices on a trailing month, trailing year, or something like that. The VIX is a measure of predicted volatility and it is derived from the prices of options on the S&P 500. Now, the way option pricing works is that the fair value of an option is a function of the strike price of the option, the level of interest rates, time, the maturity, all of which are known in advance. The most important component of the price of an option is the volatility of the stock on which the option is written. The higher the volatility is, the greater will be the fair value of the option. This has been a relationship that's been well understood in financial theory for 50 years or so. There is an active market in trading options on the S&P 500. And by looking at the prices of those options, we're able to infer the level of volatility that investors are expecting. So VIX, in a sense, is something you can't observe directly. You can only compute it from the price of a set of options. That's what it is. It's a prediction of future volatility that's derived from a very active options market.
Nathan Hunt: I've heard the VIX referred to as the market's fear gauge. Based on the VIX and what you're seeing right now, how much volatility is the market expecting in the near term? And then the medium term?
Craig Lazzara: The easiest way to answer the question is to look at current levels of VIX. Now VIX says, as you alluded in your introductory comments, VIX has, at volatility, has fluctuated quite dramatically in the past two months. In fact, VIX reached an all-time high, roughly 80, in the month of March, about a month ago. Today it's closing roughly 37-38 range, so well down from the 80. The reason it's called the fear indicator, fear gauge, as it often is, is that obviously when investors are fearful, when they, when there's lots of uncertainty, they want to buy options for protection and therefore the price of options goes up with fair value of VIX goes up. The way to interpret a VIX of 80, say, which is what we saw as recently as a month ago, is that the market expects--an 80 is an annual rate, so you've got to back that out mathematically as or what does that mean in terms of the daily price fluctuations? It means daily price fluctuations in the range of four and a half to 5%, and as the VIX has come down since then, if we're roughly now at a level of maybe 40 or so on the VIX, that would tell you to expect daily price fluctuations in the neighborhood of say, one and a half to two and a half percent. So lower than than it was a month ago. That's still quite a bit above the long-run average, because long run average VIX is somewhere just shy of 20 so we're still well above, well above the long run average levels.
Nathan Hunt: In terms of the recent behavior, is this behavior unusual?
Craig Lazzara: It's not unusual given what we see going on in the market and the economy. What I mean by that is that whenever you see dramatic falls in the equity market, it's common to see rising VIX levels. Now at the same time, it's important to recognize that the nature of the market that we're now going through, the descent from the high of the S&P 500 was on February 19th. If the March 23rd-March 24th level was the low--it's the low for now, and I sincerely hope it remains the low-- but if that stays the low, that represents a decline of 34% from the high to the low. And that took roughly a month to happen. The last time we had a really bad market and the global financial crisis, it took more than a year for the market to decline as much as 34% and the ultimate decline was at 55 or so. But the first 34 took a year. So things are happening much more quickly now than they did 10 years ago. And what's true in the equity market is also true in the volatility market. VIX has accelerated very, very rapidly. 80 is a record, I think the old record was in the 60 range, so, you know, we did set a record VIX or indicating a record level of uncertainty. There's the saying and, uh, well, I, I'm, I'm not particularly a student of Russian literature, but I do know that the first line of Anna Karenina, Tolstoy says, "All happy families are alike; every unhappy family is unhappy in its own way." And bear markets are like unhappy families. They're all unhappy in their own way. The thing that has driven this bear market is very different than the thing that drove the financial crisis, that's very different than the technology bubble, and that's reflected in the behavior both of stock prices and VIX levels.
Nathan Hunt: So the VIX went to sort of a historic high of around 80. It's now in the 40 range. To what do you attribute the increasing stability or reduced volatility from that high to that still high, but not as high?
Craig Lazzara: Yeah. I think what investors are anticipating, to you use the epidemiological phrase, is that the curve has been flattened. In other words, that the global economic shutdown, which was designed to control COVID-19, has in fact worked well enough that the economies will begin to get back to normal. It's probably a long time before you have to get back to anything that one would call normal. But get back to normal starting relatively soon. And it wasn't clear, you know, coming into the, uh, the end of March when VIX reached the record level. It wasn't clear how long the economic shutdown would have to go on. The impression I have now is that, you know, well, if we saw on the news yesterday, various governors are meeting to say how can we begin to go restart our economies, as an Eastern group and a Western group and the white house, of course, was talking about the same thing. And Europe is, at least in parts, it is doing the same. So we begin to see headlines and glimmerings from the news that say the economy will begin to bottom out and to get back to normal. It'll take a while to get there; I have no illusions about that. But I think that's why you've seen a descent from 80 to 40. Now, interesting comment about VIX or a property of VIX, I should say, this is what people who trade volatility will tell you this all the time: that VIX takes the elevator up, but the stairs down, and when it goes up, it goes up very rapidly. And when it comes back down, it comes back down much more slowly. And so when it got to 80, it had been at 20 not too long before, so it had went through 40, like nobody's business. So it's coming down slowly. If the news continues to be relatively favorable, I would anticipate that it will continue to come down a little bit more, but it'll be awhile before we see 20 again. I don't think we should anticipate that. That's simply, to translate that into stock price terms, all that means is if the average daily move when the VIX is at 80 is anticipated to be in the 5% range, and now when it's just 40 it's more in the two and a half percent range, you know, when if got back down to the 20 range, the 20 range for VIX, that would reflect an anticipation of daily price moves of maybe a percent or so. Then it'll be awhile before we see that, and therefore, you know, when we see big moves up or big moves down, that's not really surprising.
Nathan Hunt: Would you expect to see volatility return to a, let's call it normal levels, once the economy is in recovery?
Craig Lazzara: I would hesitate to predict how long it will be before we see a 20 VIX again. I think certainly that directionally Nathan, I think you're absolutely correct. As we proceed toward a relatively normal economic environment, you should see VIX on a, on a relatively steady and slow descending path, but that could go wrong. Obviously, there could be a secondary outbreak. Some economies that begin to reopen might have to be re-shut. So there are all sorts of potential bumps in the road. I mean, that's why we're at 40 now and not 20 if people think it's probably going to be okay, but we realize that we may be wrong, there's still a lot of uncertainty, much of which is connected to lack of, still so far, scientific understanding of exactly what one can do, what we can do to either vaccinate against or control this new virus.
Nathan Hunt: A lot of the volatility in the markets thus far has been focused on the lack of demand during the lockdown. Would you say that supply disruptions or potential supply disruptions are also priced into the VIX at this point in time?
Craig Lazzara: It's hard to say. I don't know how you would decouple the two because obviously there's a demand problem as the U.S. economy shuts down. The supply chain issues are harder to see in the sense that if you know, we'd like to manufacture, let's say, face masks here, but maybe some material for the masks comes from some place where that economy is also shut down. The workers can't work and so forth. Those are harder to to discern. And so it's really to me, not possible to say that if only the demand issues were priced into VIX, it would be at one level, but demand and supply together give it another reading.
Nathan Hunt: Is volatility particularly challenging for passive investors, or is it generally a challenge for active investors as well?
Craig Lazzara: Uh, yes, that's a good question. It is a challenge for both. And then the challenge for passive investors relates to what we said earlier, and that is simply that high levels of volatility typically occur in the presence of bad markets. And so we've certainly had a climb, it's recovering now from its trough, but certainly we're well below the peak we reached on February 19th. So from a passive investor standpoint, your portfolios are worth less. That's not a pleasant feeling. And so there is that challenge in the passive world. Now, the same applies to active investors with an important caveat, and this is a really interesting subtlety. The ability of an active manager, say, an active stock selector, to add value obviously depends in part on his skill level. Depends importantly on the skill level. But it also depends on the level of opportunity that the market presents. And we'll give you an example. If the difference in price in a given year between the best performing stock in the S&P 500 and the worst performing stock is 10%, that gives an active manager a relatively constricted ability to add value. The best they can do is buy something that's up 10% more than the worst. If the difference between the best performing stock and the worst performing stock is 200%, that's a much better opportunity in which to add value. So the more disperse stock returns are, the more opportunity there is for active managers to add value. Whether they actually do it as a separate question. But the opportunity level has improved. Now, one of the things that's quite true about stock market volatility is that it is related to the degree of stock level dispersion. In other words, when the market is highly volatile, dispersion among returns tends to be high. When dispersion among returns is high, that's typically a time when active managers have the opportunity. To add value. So the answer to your question, is volatility particularly challenging for active investors? It creates an opportunity. If you're good, you could have a really good year. If you're bad, you could have a really bad year, but the level of opportunity is much higher today. Dispersion is much higher now than it was a year ago. One of the things that has been a handicap to active investors for the past half dozen or so years has been the dispersion, certainly in the S&P 500 and in our global indices as well, dispersion has been well below average. When dispersion is below average, the value of active management skill is lessened, typically because the level of opportunity is less. So now that dispersion is way above average, the level of opportunity is higher and some active managers I'm sure will be successful in taking advantage of it and some others will suffer from being on the wrong side.
Nathan Hunt: During periods of high volatility, what investment strategies have historically been effective?
Craig Lazzara: If you look at equity strategy, starting with that, equity only strategy, I should say, there are a number of what we call factor indices. When I say factor, I mean a quality and attribute with which excess returns in the stock market are thought to be associated. So Fama and French, for example, famously about 20 some years, well, 30 years ago now, published a paper saying small size and cheap valuation were factors of return, qualities with which excess returns are associated. So there are a set of factor indices that typically do relatively well when the market falls and relatively badly when the market rises. They are risk mitigators, so to say. I would include in those low volatility strategies, dividend strategies, strategies that tilt toward higher quality companies in terms of high profitability and strong balance sheets and things like that. They're not infallible, certainly, but historically in down markets, those kinds of strategies have been effective. There's a second group of strategies, and I'll call for lack of a better term, asset allocation strategies. For example, some strategies aim at a particular target level of volatility. A level of volatility of say 10%, so if the stock market has a volatility of 20, you'll be 50% in stock and 50% of the cash. If the stock market's volatility doubles, you'll have your stock exposure. Those kinds of risk control strategies, target risk strategies, have typically done relatively well in declining markets. And finally, there are some, for the brave or the very cautious alike, there are some strategies that actually try to own volatility. In other words, they own futures on the VIX index in an attempt to benefit when volatility spikes upward and they all show in high volatility or sustained high volatility strategies tend to do fairly well.
Nathan Hunt: So the normal state of the VIX futures market is, uncertainty increases over time. As you move out from the present moment, you know less about what the future is going to hold. What does it mean when the VIX futures curve is in backwardation?
Craig Lazzara: Backwardation is a futures term of arc, which may be, if you have a futures contract where delivery on anything can be a, you know, a stock index, grain, whatever. As you say, typically as you go farther out in time, there's more uncertainty. When the curve slopes upward, so the more distant contracts cost more than the near-term contracts, and that's called contango, that's the normal state of affairs, typically. Backwardation is when that's reversed, the near-term contract costs more than the far contract. And in the case of the VIX indices and of VIX futures, as you note, we had been in backwardation for a while. What that typically means is there's extreme near-term uncertainty. Normally you would expect more uncertainty as you go out farther and farther. We're more certain about what will happen next month than we are about what will happen next year. But if you're in an environment of extreme uncertainty as we have been, they certainly as we were when VIX peak in March, then it's not unusual in that environment and only in that environment, it's not unusual to see backwardation or the near term futures cost more than the futures do farther out. It's unusual, but it simply reflects very high levels of near term less certainty.
Nathan Hunt: Does that mean that the markets, at least as expressed in the pricing of options, are long-term optimistic about the future?
Craig Lazzara: That's a great question. I think it certainly means that markets are more optimistic about the long-term than they are about next month in the sense of the implied level of volatility. Over the next month is higher then the implied level of volatility over the next year say, and that's very much a reflection of the fact, as we said earlier, that when volatility declines, it declines relatively slowly and so you see this downward sloping now. This is the slope of the curve sloping downward and in backwardation in the VIX futures. I think that's a possible interpretation that in the long run, the market thinks everything will be okay. And if you look at the history of the S&P 500, for example, and other indices similarly, it's clear that that conclusion is based in real experience. I mean, the S&P 500 has gone up at a rate of, uh, you know, going back to 1926 almost 10% compounded per year. So if you look at a graph of the S&P 500's total return over time, you can see the Depression; if you squint, you can see the bear market of the early seventies; you have to squint and very hard to see 1987. In 1987, the market fell 25% in one day. So the, the general direction of economic growth in the US has been upward. And it's not surprising that in the long run people who buy protection on the S&P 500 and the VIX are reflecting that in their pricing.
Nathan Hunt: As you look over the markets today, can you think of a historical parallel for what we are living through at the moment?
Craig Lazzara: Not really. I think this is, as I said, all unhappy families are unhappy in their own way. What's unique about what we're going through now? I'll answer in part by comparison with the financial crisis. Markets in the financial crisis, the peak was in October 2007. In October 2007, Bear Stearns was still in business. Lehman Brothers was still in business. AIG hadn't been bailed out. The automobile companies were still in business. All of these things that were going to happen in the next year were yet to be discovered as problems. And it took a while for that discovery to take place and to unfold. And then the policy responses took a while to be discovered, to be decided, and to take effect. In contrast now, there's no question what's going on. You know, there's a virus. In some people, it's relatively insignificant. For some people it's very serious. A lot of people have died. There was a decision, I think globally, relatively few exceptions, that the only way governments could figure out to prevent deaths from being very high was basically to have a coordinated depression. And so that's more or less what's happened certainly in the US, and other countries as well. Everything just shuts. All non-essential travel is supposed to shut, non-essential business shuts. Walk down the street and you know, all the restaurants are closed. Big companies are laying people off. The evidences of what's going on are very clear, but the cause is also very clear. It's not like the financial crisis where you had to figure out where there were some bad credits that were packaged in certain ways and the packaging was sold to certain other holders. All that had to be discovered. It was obscured at the beginning but there's nothing obscure about this. There's a virus and there's a public health response and a public health response to deliberately to suppress the economy, and that's what's happened. It is to that, that I attribute the speed of what's happened both in the volatility markets and VIX and in the stock market. Remember you said earlier, the market decline from peak to what I hope will be the trough from February 19th to March 23rd or fourth, the decline was 34% in a month. That took a year, literally, in the financial crisis. And so we're moving much more quickly. But I think the speed of the move is driven by the clarity of the problem. And if we're fortunate, the recovery will also be foreseeable because if we are able by social distancing and frequent hand washing and wearing masks on the subway and things like that, if we're able to keep the level of infection at a reasonably low level, then economic activity can begin to increase, and that's why I think you see, as you go farther out in the VIX curve or elsewhere, you begin to see investors willing to say, the economy's going to come back. This is not like the big shock of 9/11, for example, in the US. One event, it was a surprise. Some physical capital was destroyed. Many people were killed. I was there that day. It's not like that. You've had deaths, yes. They're more spread out--there are more deaths in total obviously than occurred on 9/11. There's been no physical destruction. When the economy is ready to come back, all the workers who had been laid off still have the skills they had, the physical capital they need to work is still there. I think when we go back to 55 Water Street, my office is still going to be there. My computer will still work. I still remember how to turn it on. All of the skills that might be disrupted in an act of physical destruction is still there waiting to begin to work again. It's just a question of having to wait until it's considered safe to do so.
Nathan Hunt: Craig, I want to thank you. It has been fascinating to talk to you today.
Craig Lazzara: Thank you, Nathan. Pleasure to be here.
Nathan Hunt: Thanks for listening to The Essential Podcast from S&P global. You'll find links in the show notes for the articles we've discussed today, as well as the link to the Indexology Blog from S&P Dow Jones Indices. To read all of our coverage of the coronavirus outbreak and markets, visit spglobal.com/coronavirus.