Macro Tsimmis

intelligently hedged investment

Another Boring Quarter of Below-Average Volatility…or Was It?

Posted by intelledgement on Mon, 11 Jul 11

The Intelledgement Macro Strategy Investment Portfolio is managed, obviously, using a macro-analysis approach. We look (primarily) at economic, political, social, and environmental factors to assess the likelihood of various potential events—e.g., Middle East conflict affecting oil supply, real estate bubble burst in China affecting oil demand, a sovereign debt default in Europe affecting all sorts of things, etcetera—and position the portfolio to avert the most likely bad consequences, if not actually benefit thereby.

So saying, generally speaking, we have little use for so-called “technical analysis”—methods of predicting stock price movements by analyzing historical data. Not to say that hedge funds that follow mechanistic, mathematical-based trading schema cannot be profitable…there are plenty that are. (Although most of those focus on sundry arbitrage opportunities that take systematic advantage of inefficiencies in the market such as the yen carry trade—and not, technically speaking, genuine technical analysis.)

Be that as it may, we do track one technical indicator here: market volatility. We do that because it’s a reasonably reliable gauge of perceived 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 based on volatility levels, the perception of risk has been remarkably low for the past two years, and is continuing to decline. The second quarter of 2011 marked another non-event, volatility-wise. Market volatility declined, quarter-over-quarter, from slightly below average in 1Q11 (daily change of ±0.58%) to notably below average (±0.54%)—from inception in 1957 to now (30 Jun 11), the all-time daily average change in the S&P 500 index has averaged ±0.62%. In fact, for the first time since the 2008 crash, volatility for the trailing twelve months (±0.59%) has dipped below the all-time average.

Volatility hit an all-time high in Q4 2008—breaking the record set in 1929 (by the DJIA)—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). Now, through the first half of 2011, volatility is ±0.56% (10% below 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.)

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%, as mentioned previously).

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.

But even if the volatility levels for this past quarter were boring, the macro situation was anything but. With the USA failing to come convincingly out of recession, now involved in three wars, and no solution to structural entitlements obligations or the growing national debt in sight, with the BRIC countries apparently slowing their growth rates, with Europe barely having dodged one sovereign debt bullet with Greece and facing several more (Portugual, Ireland, Italy, and Spain, at least), with unrest in the Middle East spreading…well, in the Intelledgement Macro Strategy Investment Portfolio, we are currently short the dollar and the S&P 500 index, and contemplating adding more short positions. A couple of years’ worth of denial on the part of the market as to how serious things are does not—in our view—obviate the need for investors to maintain some insurance against a sudden and severe downturn, should some bad combination of these various exigencies come to fruition.

Previous volatility-related articles:

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