Low volatility giving investors 'false sense of security'

While bond yields have some investors concerned about a squeeze on stocks, others are second-guessing whether low market volatility is too good to be true. Qontigo Managing Director of Applied Research Melissa Brown analyzes the relationship between equities and volatility levels.

"Low correlation between stocks tends to drive volatility down, but it's not clear to me, correlations have gone up and volatility has still stayed relatively muted," Brown says to Yahoo Finance, adding: "But then we see some bad news comes out, the already negative sentiment starts to kick in. And then you have everybody heading for the doors because it doesn't look like they've been expecting this bad news that may be coming out."

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Video transcript

JOSH LIPTON: Given all these different cross currents-- so the drama in DC and earnings, geopolitical risk-- still seeing a relatively low level of volatility. What explains that, do you think?

MELISSA BROWN: Well, I'm not sure I know exactly what explains it. Until recently, we had many stocks that were kind of, you know, moving. You had the magnificent seven. Then you had, you know, other stocks. They were not necessarily moving in the same direction. So low correlation between stocks tends to drive volatility down, but it's not clear to me-- correlations have gone up, and volatility has still stayed relatively muted.

We think that there might be a false flag there, that investors are perhaps getting a false sense of security by this low volatility. But then we see some, you know, bad news comes out. The already negative sentiment starts to kick in, and then you have everybody heading for the doors because it doesn't look like they've been expecting this bad news that may be coming out. And so that's a big concern. In general, low volatility can be considered to be good, but it's not always good. And, in fact, before other market peaks, it has been relatively low.

JULIE HYMAN: So, Melissa, does that imply here that investors need to get more defensive or they need to hedge their more bullish positions in case of more negative surprises?

MELISSA BROWN: I think that certainly caution is in order. You know, we want to continue to watch as earnings are coming out and see what the reactions are. But in general-- and I tend to be relatively cautious anyway, but I think that taking a more cautious stance, perhaps by hedging, perhaps by just, you know, kind of moving from riskier stocks to less risky stocks or moving from stocks to bonds, it doesn't seem like that is going to be a terrible call, you know, given this kind of environment.