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The VIX index – a measure of the expected volatility of the S&P 500 – has fallen towards 17 this month, its lowest level since the onset of the COVID-19 crisis. This has coincided with the S&P 500 breaking above 4,000 for the first time ever. According to economists at Capital Economics, falling VIX doesn’t have to herald a correction in US equities.

See:  S&P 500 Index climbs above 4,000, further upside ahead –  UBS

Low levels of expected volatility have sometimes been followed by major drawdowns in US equities

“There may be growing concerns that a correction in the  S&P 500  lies around the corner because the expected volatility of the index has fallen to a pre-pandemic low.  On the contrary, we think that the S&P 500 will remain underpinned this year by a strong economic recovery aided by very accommodative monetary and fiscal policy.”

“While the recent decline in the VIX index might convey the impression that investors are becoming too complacent, it is perhaps surprising that it hasn’t fallen more quickly and to an even lower level. After all, expected volatility tends to be informed by the volatility investors have observed in the past. And the 30-day volatility of the S&P 500 had already dropped to near a pre-pandemic low earlier this year.”

“The VIX index remains even now significantly higher than it was before the crisis took hold. This may be partly due to very strong demand for call options on individual equities, which has driven the overall put/call ratio for them down sharply.”

“The strength of demand for call options on individual equities could itself be construed as a worrying sign. But there is no evidence of a surge in demand for call options on equity indices, which might have also been expected if investors were throwing caution to the wind.”