Macro Tsimmis

intelligently hedged investment

Judging by Market Volatility, All is Well

Posted by intelledgement on Mon, 11 Apr 11

The first quarter of 2011 marked another non-event, volatility-wise. Market volatility did tick up, quarter-over-quarter, from the extraordinarily low 4Q10 reading—the lowest level of volatility in three-and-a-half years—but remained 6% below average. For six of the last seven quarters now, the S&P 500 index has experienced an average daily change of close to the all-time (since inception in 1957) average daily change of ±0.62%.

Volatility hit an all-time high in Q4 2008—breaking the record set in 1929—with mind-boggling peak average daily change of ±3.27%. (That’s a whopping 427% above the average.) For 2008 overall, it was a record ±1.71%, or 176% above average. But since then, it has been dropping steadily: ±1.19% in 2009 (92% higher than average) and ±0.74% last year (19% above average). The following chart tracks the annual average daily volatility for the S&P 500 index from 1950 to 2011. (Note that while the index was implemented in 1957, in order to get the most meaningful/largest feasible data set, we include retrospective data back to 1950.)

We track market volatility because it’s a reasonably reliable gauge of risk levels. Roughly 73% of the time, when volatility in the S&P 500 goes up—when the average annual daily change in the price of the index (up or down) is greater than it was in the prior year—market performance for that year declines compared to the prior year. And when volatility declines year over year, market performance improves 55% of the time.

The following chart shows the quarterly fluctuations in volatility levels for the S&P 500 (red line) from a year before the crash—the fourth quarter of 2007—to the present, compared to volatility measurements of the Dow Jones Industrial Average (blue line) from a year before the 1929 crash. (We use Dow volatility data for the 1929 crash because the S&P 500 was not around back then.) Also shown in the chart is the average daily volatility level for the S&P 500 (±0.62%)

Of course, the fourth quarter of 1929 was just the beginning of an extended period of market decline that persisted for years. Consistent with our research into the relationship of market volatility and performance, volatility levels in the 1930s continued to surge well above normal. Thus, it is encouraging that the trendlines have been diverging for the past two years.

Having said that, it’s important to keep in mind that volatility is not a leading indicator; black swan events engender volatility, not the other way around. Should Italy or Spain default, should Iran attack or be attacked by another country, should rising sea temperatures set off a major extinction event—or any equivalent event occur—then all bets are off.

But for what it’s worth, the current consensus of U.S. investors continues to be that the worst is behind us, and that risk levels going forward are no longer elevated.

Previous volatility-related articles:

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