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Learning to Love Volatility

By admin_45 in Blog Learning to Love Volatility

Of everything that impacts the capital markets, behavioral biases are often the most underappreciated. We try to keep this in mind as it can provide insight into the bigger picture. Take the recent onslaught of volatility, for example: is it just normal market churn or does it presage more trouble ahead?

We take the former view, but understand investors’ concerns as it is easy to get anchored into the low volatility mindset of the past few years. With that backdrop, the snapback in volatility could seem unsettling and/or unusual. Consider these three points, however, of data we closely monitor that shows it is more typical than some investors may realize:

#1 One percent days per year: The average number of days the S&P 500 has rallied or declined each year by 1% or greater is 53 since 1958 (the first full year of real time data for the index). That translates to roughly a 1% day/week per year. To show just how calm the markets were in 2017, there were only 8. So far this year even without finishing Q1, there have already been 11.

How common has recent volatility been on a quarterly basis? The average number of 1% days each quarter is: 12.9 (Q1), 13.1 (Q2), 13.1 (Q3), and 13.9 (Q4). Last year, there were just two 1% days in Q1 and Q2 respectively, four in Q3 and none in Q4. So far this quarter, we are short about 2 such 1% days, but still have 24 trading sessions left.

#2 Monthly volatility: With the VIX closing at 37.32 on February 5th, many investors may think that was the high for the year. Historical monthly patterns in the VIX, however, could prove otherwise. Since the data started in 1990, the VIX has only peaked once during this month in any year. For the rest of 2018 we are more likely to see the VIX reach a high in August (5 observations since 1990) or October (also 5 observations).

By contrast, months in which volatility could subside include July (6 bottoms for the year), and December (8). If you’re wondering about March as we finish out the quarter, the VIX has peaked once during this month in 2004, and has bottomed twice (in 2002 and 2013).

#3 Returns during volatile years: Just because US equities are more volatile does not mean negative price returns, at least when looking at the historical data. Despite day to day volatility, the S&P 500 has only posted negative returns 20% of the years since 1958. Additionally, during years with above average numbers of 1% days, the majority of years (67%) ended higher. The average performance during those positive years was +19.3% compared to (15.1%) for down years with above average 1% days.

In sum, we expect more volatility in equity markets in the coming months.We believe this is a mean reversion year to more normal market activity with higher volatility given the advent of higher rates/inflation/deficit spending. We are still bullish on US equities, but expect to see greater daily swings. As our data shows, that’s not necessarily a harbinger for trouble, but does require a stronger stomach and more due diligence to not fall prey to behavioral biases.

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