Is US Equity Volatility Too Low?

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Is US Equity Volatility Too Low?

For Data today we want to talk about US equity volatility, which has declined very quickly of late, especially as measured by our favored metric of one percent days. We like it because it measures how much investors “feel” real-time volatility with a simple count of trading sessions when the S&P 500 moves more than 1 percent up or down from close to close. Any one-day move greater than 1 pct to the upside or downside is +1 standard deviation from the S&P’s mean daily return back to 1958 (first full year of data).

Some datapoints to consider on this topic:

  • 2020 was a period of truly outsized volatility, with 110 1-percent days. Getting +100 1-percent days has only happened 7 times since 1958. The other 6 instances were: 1974 (115 one percent days), 2000 (103), 2001 (107), 2002 (126), 2008 (134) and 2009 (118).
  • 2021 has been much quieter. Through the first 4 months we’re annualizing at a run rate of 66 1-percent days versus the long-run yearly average of 54. That may sound like 2021 is still running pretty choppy, but keep in mind that usual Year 2 after a +100 1-percent Year 1 sees Q1 volatility run an average of 27 1-percent days. Q1 2021 had just 18 such days.
  • April 2021 showed entirely normal 1-percent day volatility – just 4 occurrences, right on top of the 1/week average noted in the prior point.

Takeaway: So far in 2021, US equity volatility is returning to normal much more quickly than after prior years of outsized volatility (+100 one percent days). The reasons why are pretty straightforward: fiscal and monetary stimulus combined with a pretty speedy vaccine rollout. The first two saw the US economy through the pandemic and the third one is ending it. That leaves us with an equity market focused on fundamental issues like positive corporate earnings leverage and that, in turn, allows equity sector correlations to decline from their panicky highs last year. The net effect: lower S&P 500 volatility, such as we’re describing today.

While all that sounds great, there’s a problem. As we have highlighted in previous notes, history says the sharp drop to lower US equity volatility we’ve been seeing may cap 2021 stock market returns. After 2000 – 2003’s higher volatility (2000-2002 all had +100 one percent days, and 2003 had 83) and a troubled bear market, 2004 only saw a 10.7 pct snapback for the S&P 500. Additionally, after 2008 – 2010’s greater number of 1 percent days, 2011 was only up 2.1 pct.

Expanding on this point, consider that the S&P rarely posts three consecutive years of double-digit returns and this is an important observation just now:

  • The S&P was up 31.2 pct and 18.0 pct in 2019 and 2020 respectively on a total return basis.
  • The S&P has registered two consecutive years or more of annual double-digit total returns 20 times since 1958. In the year after those instances (excluding 2020), the S&P was positive a little over half the time (58 pct) and up +3.6 pct on average on a total return basis.
  • Since 1958, the S&P only went on to produce a positive double-digit return for a third straight year or more during 3 periods.

    1963-1965: 1963 (+22.6 pct), 1964 (+16.4 pct), 1965 (+12.4 pct)
    1995-1999: 1995 (+37.2 pct), 1996 (+22.7 pct), 1997 (+33.1 pct), 1998 (+28.3 pct), 1999 (+20.9 pct)
    2012-2014: 2012 (+15.9 pct), 2013 (+32.1 pct), 2014 (+13.5 pct)

Bottom line: 3 years of double-digit S&P 500 returns have historically required a mid to late-cycle investment environment with robust economic growth, not the technically early-cycle environment we find ourselves in today. The difference this time is we’ve had +$5 trillion in stimulus pumped into the American economy. Even still, history shows that a third year of double-digit returns is unusual, and typically comes amid easing financial conditions and improving earnings such as during the bull run of the 1990s or after the Financial Crisis. Could that happen again with an accommodative Fed and a Democratic President and Congress pushing for more fiscal aid? Yes, as long as rates don’t’ rise too high.