By Joe Mallen and Chris Shuba, Helios Quantitative Research
As Mark Twain so famously put; “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
Most investors focused on building wealth wonder if staying the course is the best policy during an extended period of low volatility with a strong up-market? Your answer is especially relevant if you fear that an uptick in volatility might signal a deep loss in market value.
Worried About Low Volatility with a Strong Market?
It is generally accepted that there is an inverse relationship between volatility and market performance. Low volatility is usually accompanied by an up-market, and vice versa.
When the S&P 500 Index consistently hits all-time highs during a period of unprecedented low volatility, as we are now experiencing, does that mean danger is around the corner? Many investors have that knee-jerk reaction during ‘good times’ because investors are suspicious and always on the lookout for signs of trouble. But, as responsible advisors, we should bear in mind the following three views:
- A period of extended low volatility does not signal that a market correction is imminent.
- When realized volatility is low, rule of thumb suggests that volatility must go up. But, the threat of increasing instability does not mean that the market is about to go down.
- The six-month average daily trading range of the S&P Index has been at all-time lows. Historically, after the trading range bottoms out, markets show consistent improvement, with only a few notable down-years on record.
Implied volatility metrics give us an indication of the market’s forward-looking risk. Since mid-2016, volatility levels hovered near all-time lows. Additionally, quantifiable measures of realized volatility and trading ranges confirmed how far risk levels had dropped. But does this scenario signal a downturn in the market?
Inevitably, market corrections occur, but can history tell us what to expect about market performance immediately following a period of all-time low volatility?
We looked at measures of both implied and realized volatility to see if historical data supports or refutes the common fear that a market correction usually follows a period of both low volatility and a high market.
Here’s What We Think
The graphs and tables below tracked the implied or realized volatility in the S&P 500 Index over the past 20+ years. The tables identify the eleven lowest volatility points by year, with the one-year return immediately following. These statistics are revealing because each looks at the market through a slightly different lens, but they all point to the same conclusion.
The data suggests that time periods during and after low levels of volatility with a high market do not signal a market correction.
Based on empirical evidence in the charts below, during a period of increasing volatility the market performance does not necessarily go down over the next 12 months. In fact, historical evidence suggests there is often at least a single digit increase.