I’m putting myself out there a little bit with this post. I had a very simple thought today about the relationship between volatility and demand for stocks. “Wow, I can’t believe CC has not put 2+2 together before.” I’m surprised I’ve never had this thought before, but I’ll share it for the benefit of others that have not thought about the relationship between volatility and demand.
While I’m somewhat embarrassed for never having this thought before, I also have not read about it in a book, on a blog or heard about it on TV. Here it is.
Think of yourself as a portfolio manager for a hedge fund. Let’s say in the back of your head you are targeting a 20% return for the year. When the VIX is at 35, you can maintain high cash positions and still achieve great returns because of the large swings in price. But what about when the VIX is at 17? You have days like today where ES is trading within a 2-3 point range. If you want to generate a big return, you need to buy more stock to make up for the smaller price movements.
So I would make the argument that as volatility goes down the demand for stock increases. Likewise, if there is an economic shock and an increase in volatility, the demand for stock goes down since the need to magnify returns goes down (you’re getting more pop from each position when the VIX is higher). Note that I’m ignoring other variables. If there is an economic shock, besides portfolio managers reducing position size because of increased volatility, they are also likely selling to reduce exposure out of fear. I’m just focusing on the relationship of volatility and demand.
If you think about things in extremes, it further illustrates my point. If the VIX is at 80, you could be 10% invested and generate excellent returns. You’re getting a ton of price movement. In contrast, if the VIX is at 5 you would likely need to deploy leverage to generate large returns.
So what does it all mean? It means that if things stay quiet and the VIX makes new lows, portfolio managers are going to need to deploy more cash (or leverage) in order to make big returns (ie., more demand for stocks). Likewise, when volatility spikes we’ll see a reduction in demand for stocks based solely on increased volatility (putting aside reduced demand due to other factors – fear, etc).
This is also somewhat of a chicken/egg problem because volatility is only going to go down if demand drives stock prices up. I get that. Still, I believe the lower volatility adds fuel to the rally. How do I prove it? Because I know that I’ll deploy more cash (or even leverage) in a lower volatility environment. I would have no problem being 80-90% invested right now if I was able to get there. But when the VIX was a 40, I would never take it that high. I had plenty of bang without deploying most of my capital. Put another way, just like a portfolio manager, I need to deploy more capital in this kind of environment to get a decent return.