Low volatility not necessarily signal of impending turmoil, Morgan Stanley says

Low levels of implied volatility do not necessarily mean that something bad is lurking just around the proverbial corner, analysts at Morgan Stanley believe.

Their comments came as the most popular gauge of volatility for share prices, the Chicago Board of Options Exchange's VIX index, dropped under 10.0, something which had only been seen on less than 10 days since 1990, in two episodes across 1993/94 and 2006/07, versus more typical levels closer to roughly 15.0.

Three-month S&P volatility meanwhile had also dipped below 10 over the previous two weeks, for the first time since at least 2000, according to the investment bank.

In a note sent to clients, the analysts pointed out how volatility term premiums, regional spreads (Europe/Japan versus US) and skew measures were in fact not as compressed as near-term at-the-money volatilities might suggest.

"Vol sellers can take comfort from the fact that S&P realised vol has stayed under 10% a fifth of the time since 1990," Morgan Stanley said.

"Risk asset performance in the previous episodes suggests that equities can do fine with only modest downside and peak-trough drawdowns in the subsequent months. The low-volatility periods can persist for at least 2-3 months after VIX hits sub 10."

The VIX is the Chicago Board of Options Exchange's index of implied volatility on options tied to the benchmark S&P 500 equity gauge.

In general terms, most investors define 'risk' as the probability of large and sharp movements in the prices for financial securities.

For practical reasons, and given the difficulty of predicting the future, those investors who are more 'quantitatively' inclined assume that past levels volatility will tend to repeat themselves in the future - admittedly a dangerous assumption sometimes.

And given the relationship between risk and reward in any investment, lower 'risk' tends to go hand-in-hand with higher returns, boosting stocks' valuations.

Simply said, a return to average levels of volatility might see a correction in stocks at some point yet leave investors unscathed overall.

"An interesting similarity between the 1993 and 2006 periods is that USD (DXY) fell in both periods to a similar extent. Admittedly, just two periods in the last 17 years isn't enough to draw any statistical significance, but looking at these two periods, it seems to suggest that VIX hitting 10 isn't necessarily an immediate signal of market turmoil."

"Stocks correlation has normalised. If we are finally in a stock- picker's market and correlation stabilises in the mid-20s like in 2005-07, equity index realised volatility can stay muted. When VIX last hit 10 in November 2006, we had to wait 7-8 months before it hits 15 again. In the 1993 episode, we had VIX spiking above 15 on the Fed hiking cycle, but these spikes proved to be short-lived."