What Low Vol Means For Equity Returns

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What Low Vol Means For Equity Returns

Even after the US killed Iran’s top military commander in an airstrike last week, the S&P 500 only dropped by 71 basis points on Friday and was even up slightly on Monday. That’s notable to us because we gauge “real” US equity volatility by tracking how many days the S&P 500 rises or falls by 1% or more in a given trading session. That Friday’s action did not breach the 1% threshold speaks to the overall low volatility environment of 2019 that has extended to this year. For example:

  • There was a total of just 38 days when the S&P had a daily return of +/- 1% in 2019 compared to the annual average of 53 since 1958 (first full year of data). Under normal market churn, there should be about one 1% day a week.
  • Our bar chart of annual S&P 1% days (above) shows a clear pattern over the last six decades. Big market swings happen during the start of a bull market, abate and then rise again towards the end of annual sequential gains in US stocks.
  • This last cycle has been more mixed than usual. The post-Great Recession low will likely be 8 one percent days in 2017. 2018 was more in keeping with late cycle norms at 64 one percent days versus the annual average of 53, but last year was below average again. We attribute this lower volatility to the Federal Reserve switching its policy back to a more dovish stance early last year.

As for what to expect ahead, a few points:

Quarterly volatility: The quarterly average number of 1% days is 13 in Q1, Q2 and Q3 respectively, and 14 in Q4. Last year, however, volatility ran below pace in Q1 (11 one percent days), Q2 (7 days) and Q4 (6 days). It was slightly above average in Q3 at 14 one percent days due to trade and recessionary concerns.

Seasonal volatility: Another way we measure volatility is by tracking how many times the VIX has peaked or troughed in each month for the year since it was created in 1990.

  • The VIX has peaked the most in January, August and October at 5 times each; in other words, those tend to be especially volatile months.
  • The VIX has bottomed the most in December (8 times), followed by July (6) and January (5).

Bottom line: history says January is either particularly volatile or calm. It’s the one month that has a high level of extremes in both directions. As for Q1 as a whole, the VIX has peaked twice in February (2016 and 2018) and has never bottomed during that month, and has peaked once and bottomed twice in March.

Volatility’s relationship with equity returns: The correlation between annual S&P 500 total returns and the number of one percent days is negative 0.38 over the past 60 years. This makes sense because choppier markets (greater number of one percent days) tend to mean lower returns amid an elevated level of investor uncertainty. For example, the high in annual 1% days was 134 in 2008.

By contrast, calmer markets (fewer number of one percent days) usually lead to higher returns. This was on full display last year, when there was just 38 one percent days, while the total return for the S&P was +30.7%.

The upshot: while volatility was below average last year, it does typically lend itself to positive returns. We think this dynamic will continue as long as Fed Chair Powell remains dovish, which markets expect. Fed Fund Futures currently give 60% odds of a rate cut this year. Of course, we’re just a few days into 2020, but that not even last week’s major geopolitical event could produce a down 1% day for the S&P shows the extent of what will have to happen to truly spook markets.