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Volatility hard to come by in equity markets

Equity market volatility has been dormant of late, but shocks could still send it closer to historical norms.

For more than a year now, the monthly average of the CBOE Volatility Index has failed to surpass the 19.5 monthly average since June 1990, according to a chart Sandler O'Neill & Partners LP analyst Richard Repetto displayed during a presentation at his company's Global Exchange and Brokerage Conference, held June 7 and 8. In the early part of June, the VIX, which measures implied volatility of S&P 500 index options, has averaged just below 10 while actual realized volatility has been below 5.0, which is a historic low going back to June 1990, Repetto said.

Market makers and trading companies tend to prefer volatility because it can create more business for them as investors reposition holdings to adjust for price changes. While the market movement has been subdued, some volatility spikes have popped up.

Such increases occurred after Brexit and the U.S. presidential election in 2016, but the levels rapidly compressed, Repetto said. That quick reduction in volatility is a big change in the market, said Emanuel Derman, a Columbia University professor and a former managing director at Goldman Sachs Group Inc.

"In the old days, meaning in the 90s, I remember volatility going up fast and coming down very slowly," he said at the conference. "Now, volatility goes up fast and comes down very quickly."

Participants at the conference gave different reasons for the lack of volatility. Citadel LLC CEO Kenneth Griffin said the likelihood of a market shock has been driven lower because the aggressive action taken by central banks around the world has created calm.

"This is putting a real damper on natural economic volatility," he said.

Nick Colas, an independent analyst based in New York, said current conditions are not conducive to volatility because, in general, earnings have been stable for about three years and investors have a good understanding of the outlook for the interest rate environment.

Colas said events such as swings in oil prices or sudden financial distress can still lead to volatility. But over the long term, he expects volatility to continue trending down because the infusion of artificial intelligence and information into trading algorithms should create more correct market prices.

"As you allow for a more efficient electronic market, it should crash less," Colas said at the conference. "It's going to have bumps along the way and crashes happen no matter what. There's just fewer of them."

Yet not too long ago, many wondered if more sophisticated trading approaches were causing too much movement to market prices, said KCG Holdings Inc. CEO Daniel Coleman.

"After Flash Boys came out, we were talking about how automated trading increased volatility," Coleman said, referring to Michael Lewis' 2014 book on high-frequency trading.

Coleman agreed with the notion that faster dissemination of information has reduced price movement, but he noted that human nature has not been completely removed from the market. He said investors can still reap financial benefits by taking risk, and that increases the potential for volatility.

"There's an overarching human element to this that if I can take on risk and be compensated for it and not be penalized, I'm going to keep doing that until I get hurt," he said.

Coleman said he did not know when, but eventually investors will get caught off-guard with a spike in volatility.

"It's going to go a lot higher at some point when we least expect it," he said.