The recent equity sell-off has focused investors’ attention
on measures of market volatility, which have been abnormally low for much of
the last four years. I did point out last summer that implied equity and
bond market had fallen to all-time lows, and that there was a risk of a nasty
surprise if investors believed that central banks would no longer continue to
provide the unlimited support that they had hitherto (here).
In the event, equity market volatility measures fell even further, bottoming out in
November, whilst both the Fed and Bank of England since have raised interest
rates.
Naturally, this raises the question, why now? And the truth
is we don’t know. Many ex-post rationalisations have been offered but I suspect
that markets had simply been living off fresh air for too long. It is thus
possible that someone, somewhere simply placed a sell order that was picked up
by algorithmic trading systems and triggered a widespread bout of selling. But
nobody was really surprised that markets did correct sharply downwards, even if
the magnitude of the correction caught many people out. Indeed, I pointed out
last summer that “if the Fed starts to
run down its balance sheet and put some upward pressure on global bond yields,
the equity world may look different.”
At this stage, I do not have enough evidence to change my year ahead prediction that equities will finish 2018 up by 5-10% on year-end 2017 levels. But that view looks a little more shaky than it did five weeks ago. Whilst much attention focused on the fact that the correction in the S&P500 on Monday was the largest single daily points decline on record, it is only the 39th biggest percentage decline on daily data back to 1980 (although that puts it well inside the top 0.5%). Slightly more worrying is the fact that exactly 10 years previously, on 5th February 2008, the S&P500 fell by 3.2% on the day – at the time, the 30th biggest daily fall since 1980. And we all know what happened later that year …
Recent trends in volatility raise a number of key questions. First, is volatility mean reverting? If so, neither the extremely low levels of 2017 nor the elevated levels of today will be sustained. Second, if market volatility measures do move back towards more “normal” levels, how quickly is this likely to occur? And third, is it possible that the trend volatility level has changed (i.e. that investors risk appetite has changed)?
With regard to the first question, the post-1990 evidence does suggest that equity volatility is mean-reverting although it can diverge from the mean for a considerable period of time. On average since 1990, each period of over- or undervaluation relative to the mean lasted for 17 months, which suggests that the period of adjustment is relatively slow. With regard to the second issue, in 88% of cases since 1990 the VIX was within one standard deviation of the mean (although on only 38% of occasions was it within half a standard deviation). One standard deviation represents a 7-point move in the VIX which is relatively tolerable. It is only when we see the kinds of spikes associated with the bursting of the tech bubble between 1999 and 2002, or the post-crisis period of 2008-09, would high equity volatility threaten to derail the markets.
However, there is a risk that an extended period of low volatility sows the seeds for a period of higher vol. Lower volatility during periods of economic upswing tends to result in higher risk taking and excessive leverage, with the result that even small price declines can force investors to dump asset holdings, depressing prices further and generating higher volatility. This triggers a second round of price declines and volatility spikes which could turn into a self-reinforcing spiral. But as it currently stands, despite the sharp spike in equity volatility in early February, the forward vol curve is pricing in a decline back to levels close to the long-run average over a five month horizon (chart). This downward sloping volatility curve is not indicative of a market which is expecting a significant change in risk conditions.
At this stage, I do not have enough evidence to change my year ahead prediction that equities will finish 2018 up by 5-10% on year-end 2017 levels. But that view looks a little more shaky than it did five weeks ago. Whilst much attention focused on the fact that the correction in the S&P500 on Monday was the largest single daily points decline on record, it is only the 39th biggest percentage decline on daily data back to 1980 (although that puts it well inside the top 0.5%). Slightly more worrying is the fact that exactly 10 years previously, on 5th February 2008, the S&P500 fell by 3.2% on the day – at the time, the 30th biggest daily fall since 1980. And we all know what happened later that year …
Recent trends in volatility raise a number of key questions. First, is volatility mean reverting? If so, neither the extremely low levels of 2017 nor the elevated levels of today will be sustained. Second, if market volatility measures do move back towards more “normal” levels, how quickly is this likely to occur? And third, is it possible that the trend volatility level has changed (i.e. that investors risk appetite has changed)?
With regard to the first question, the post-1990 evidence does suggest that equity volatility is mean-reverting although it can diverge from the mean for a considerable period of time. On average since 1990, each period of over- or undervaluation relative to the mean lasted for 17 months, which suggests that the period of adjustment is relatively slow. With regard to the second issue, in 88% of cases since 1990 the VIX was within one standard deviation of the mean (although on only 38% of occasions was it within half a standard deviation). One standard deviation represents a 7-point move in the VIX which is relatively tolerable. It is only when we see the kinds of spikes associated with the bursting of the tech bubble between 1999 and 2002, or the post-crisis period of 2008-09, would high equity volatility threaten to derail the markets.
However, there is a risk that an extended period of low volatility sows the seeds for a period of higher vol. Lower volatility during periods of economic upswing tends to result in higher risk taking and excessive leverage, with the result that even small price declines can force investors to dump asset holdings, depressing prices further and generating higher volatility. This triggers a second round of price declines and volatility spikes which could turn into a self-reinforcing spiral. But as it currently stands, despite the sharp spike in equity volatility in early February, the forward vol curve is pricing in a decline back to levels close to the long-run average over a five month horizon (chart). This downward sloping volatility curve is not indicative of a market which is expecting a significant change in risk conditions.
As for the third question of whether there has been a shift
in the trend level of the VIX, and therefore a shift in investor risk
tolerance, the jury is still out. We will probably only know after a prolonged
period of tighter monetary policy. The most four dangerous words in finance are
“this time it’s different.” Any data series which shows strong mean-reverting
trends should be treated as such until we have overwhelming evidence to the
contrary.
All in all, I am inclined to treat the current trends in markets as some of the air coming out of the bubble rather than as the beginning of a more prolonged sell-off. As many people have pointed out, the fundamental factors which drove markets higher in the first place – strengthening growth and the impact of US tax cuts on corporate earnings – remain in play. But the spike in volatility acts as a reminder that markets are like wild animals: they can act unpredictably and you can never tame them, so you have to act cautiously to avoid getting your face ripped off.
All in all, I am inclined to treat the current trends in markets as some of the air coming out of the bubble rather than as the beginning of a more prolonged sell-off. As many people have pointed out, the fundamental factors which drove markets higher in the first place – strengthening growth and the impact of US tax cuts on corporate earnings – remain in play. But the spike in volatility acts as a reminder that markets are like wild animals: they can act unpredictably and you can never tame them, so you have to act cautiously to avoid getting your face ripped off.
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