Another Reason For The Low VIX

Since the Great Financial Crisis, and the unprecedented expansion of the balance sheet of many central banks, many investors think that officials are responsible for various distortions that they detect in the capital markets. The compressed nature of equity market volatility is one of those distortions. 

However, the decline in the S&P 500 volatility (VIX) became most pronounced last year, when it frequently slipped below 10% and did not get above 20% even once. After raising interest rates once in 2015 and once in 2106, the Fed’s normalization accelerated last year with three rate hikes and the beginning of the unwinding of its balance sheet. 

Let’s concede for the purpose of this argument, that the Federal Reserve’s purchases of Treasuries and MBS, displaced investors and encouraged them to buy higher risk assets. Among these riskier assets are equities. Hence the idea that the Fed’s QE helped fuel the stock market rally. As equity prices rise, the volatility typically declines. 

While accepting this logic, another force seems at work and it cannot be simply reduced to the Fed’s QE: corporate share buybacks. From 2009 through 2017, the Federal Reserve’s flow of funds shows corporates bought back $3.3 trillion of shares. They are the most significant buyer of US shares. 

Households sold roughly $670 bln of US equities, and insurers and pension funds have sold about $1.2 trillion. of US shares. Mutual funds and ETFs bought about $1.6 trillion worth of US shares, offsetting most of the selling. The IMF noted last year that “large US corporations have experienced a negative net equity issuance of $3 trillion since 2009 through share buybacks.” 

Why do corporations buy back their own stock? The first and simplest answer is because they can. Before 1980, the SEC prohibited such activity on grounds of potential manipulation of share prices. The second answer is that they can in the sense that they have the mean: strong earnings growth and share buybacks, like dividend, return unwanted/unneeded capital back to shareholders.