Can Volatility History Teach us Anything?

There are no short cuts to easy profits, but sometimes Mr. Market throws us a bone (or two) in our quest for strategic insight. Two examples, though hardly the only ones, come by way of reviewing correlation and volatility histories. We surveyed correlations last week, and today we revisit volatility, as per our chart below, which graphs rolling three-year volatilities of monthly total returns back to September 1994.

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The obvious trend is that there is one, or so it appears. Lulls in vol tend to be followed by surges, and then lulls, and round and round we go. It’s all obvious in hindsight, of course, but dissecting where we are in real time and how long it will last (or not) is always more obscure.

Meanwhile, we’re constantly fighting our own biases. That’s partly because the mind likes to extrapolate recent activity far into the future. Back in the late-1990s, the calm in volatility readings was thought to be the dawn of a new era in smooth and high returns in stocks and other risky assets. Such thinking prevailed right up until the idea was beheaded in the crash of 2000-2002, a reversal of fortunes that was accompanied by a spike in vol.

Something similar unfolded during 2003-2007, when returns generally were strong and standard deviations were low. Once again, it was all too easy to believe that the trend would last. It didn’t, leading to a collapse in returns and a swelling in vol.

It’s always hazardous to speculate on when a current cycle will end and a new one will begin. Nonetheless, we can and should observe cycles for what they are: finite. The one that now has the world by the neck may appear set to roll on indefinitely, but that is an illusion. This too shall pass, although the timing, as always, is unclear.

We can, however, search for some perspective, and to some extent we can find it. Granted, it’s thin and subject to revision on a moment’s notice. As such, we must be wary, even when it seems as though we’ve stumbled upon something meaningful. With that caveat in mind, consider our second chart below, which can be read in context with the first graph above. Note that relative high performance tends to be accompanied with relatively low volatility. No, it’s not a perfect match, but there’s a general rhyme here, or so looks to our eyes. Similar trends pop up over longer histories as well.

In fact, we suggested as much back in early 2007, noting at the time that the lows in vol looked worrisome. One reason for our concern then was the history of blissful marriage of low vol and high returns ending with a spike in volatility and lower if not negative returns. Does it always unfold like that? No, but it’s occured enough over the decades to keep us wary, and watching the trends.

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Keep in mind that in both charts we’ve smoothed the data, i.e., the lines reflect trailing 3-year trends. As such, none of this is much help to the day trader and it’s only of limited help, if any, to strategic-minded investors. Nonetheless, the graphs suggest that the current rise in volatility is still quite young, or so it appears next to the previous stumble in 2000-2002.

One could argue that volatility is still rising and returns are still falling. Indeed, trailing 3-year returns, although they’ve fallen sharply this year, are more or less flat. By comparison with the previous cycle, can we expect some red ink in trailing three-year returns and perhaps some higher volatility yet? Let’s not rule it out. Even if vol has reached its highs this time around, it wouldn’t be out of character for standard deviations to persist for a time.

Considering all this, one could reason that the correction still has a ways to go. Again, that’s pure speculation and so it must be taken with a grain of salt. What’s more, volatility and correlation offer only two perspectives, and by themselves they’re of limited value, which is why we also review a number of other metrics, including dividend yields, economic conditions, and so on.

Summarizing our research, only of which a portion appears on these pages, we expect that the correction will roll on, although we’re generalizing broadly in terms of asset classes. Some look better than others at this point, and that informs our asset allocation. But to the extent we’re making general observations, volatility is just one reason. The economic outlook weighs heavily on our thinking, too. And for the moment, it’s unclear just how much blowback is coming to Main Street.


Originally published at The Capital Spectator and reproduced here with the author’s permission.