Performance and Volatility: an Inverse Relationship

Volatility in the ebb and flow of the S&P 500’s valuations declined for the third straight quarter in 3Q09. The average daily change in the value of the S&P 500 index for 3Q09 was ±0.8%, down sequentially from ±1.3% in 2Q09, from ±2.0% in 1Q09, and a nightmarish ±3.3%—the highest level of volatility in a quarter since the inception of the S&P 500 index—in 4Q08 (as discussed in the previous articles, This Volatility is Off the Charts! in April 2009 and Not Your Father’s Market Volatility in July 2009).

For the entire year, 2009 at ±1.3% overall is still on track to be the second most volatile year on record—2008 set a new record at ±1.7%—but if the calming trend continues through 4Q09, we may drop below the pre-2008 record ±1.2% posted in 2002. Still, at this point we remain 118% more volatile than “normal” (namely, the all-time average daily change in the value of the S&P 500 index, which is ±0.6%).

Why do we care? Well, if you are a short-term trader, obviously more volatility is a good thing, because the opportunities for you to profit are larger and more frequent. But it turns out that if you are a long-term investor, volatility is bad news. In general, higher volatility is associated with a lower return-on-investment. Indeed, the big peaks in the above chart—when the S&P 500 experienced unprecedented volatility—were all negative ROI years: 1974 -30%, 2002 -23%, and 2008 -38%. In fact, not merely negative, but the worst three years in the history of the S&P 500 index.

But wait, there’s more! It isn’t just peak volatility that hurts. In general, the higher the volatility, the worse the ROI. Check out this chart measuring performance at various levels of volatility:

To build this chart, we calculated the ROI for the S&P 500 index for each year since 1950, and then sorted those years by the average daily change in the S&P 500 index—up or down. Clearly if you are a long-term investor seeking a 10%-or-better annual ROI, you want to root for average daily volatility around ±0.6% or less. In years when average daily volatility has exceeded ±0.8%, the S&P 500 has a negative ROI, including those three major meltdown years.

We also did a little vector analysis. Since 1950, there were 29 years in which volatility declined from the prior year and in 18 of those (62% of the time), performance improved compared to the prior year. There were 30 years in which volatility increased from the prior year, and in 24 of those (80% of the time) performance was worse than the prior year.

We are not saying that volatility causes market declines; in fact, it presumably works the other way round. But if you are a long term investor and detect a rise in volatility, be prepared for an increased probability of sub-par performance by the stock market.

Still not your father’s volatility

The second quarter of 2009 is over and there’s good news and bad news on the volatility front.

First the good news: the average daily change in the value of the S&P 500 index for 2Q09 was ±1.3%, down sequentially for the second consecutive quarter from ±2.0% in 1Q09 and a nightmarish ±3.3%—the highest level of volatility in a quarter since the inception of the S&P 500 index—in 4Q08.

The bad news is that we still have a long way to go to get back to what we like to think of as “normal”—March 1957-to-June 2007, when the average daily change in the value of the S&P 500 index was ±0.6%, and more than half the time—53% of all market sessions during those 50 years—the change in the index rounded to the nearest whole number was 0%. We had such quiescent sessions just 29% of the time in 2Q09.

While the immediate trend shows dampening volatility, on a year-over-year basis, so far 2009 is looking much more volatile than 2008. 1Q09 was 57% more volatile than 1Q08 and 2Q09 was 67% more volatile than 2Q08. This is deceptive, however, because the vast majority of the craziness in 2008 occurred during the second half of the year. Through the first six months of 2009, we are seeing an average daily change of ±1.6% which looks bad compared to the first six months of 2008 (±1.2%) but is squeezing in under the full year 2008 figure of ±1.7%. Unless things become unglued again down the stretch in 2009, the year-over-year comparables are likely to get considerably better.

So, who cares about volatility levels? Well…you do…or at least if you are a long-term investor you should.

In April, we reported that during the 50 years when the market experienced daily volatility averaging ±0.6%, it performed well, and that the poor performance that has pundits proclaiming the death of “buy-and-hold” as a viable strategy is associated with this volatility singularity that we are currently experiencing: daily volatility of ±1.5%—150% higher than normal!—for the last two years. To gain that outlook, we analyzed daily performance data between the present and March 1950, but in conducting subsequent research, we determined that the S&P 500 per se was created in March 1957. The earlier performance data posted on Yahoo! is presumably derived.

Excluding the 1950-to-1957 data is painful, because the market was up a compounded annual growth rate of 14% in that period, but doing so doesn’t change the overall picture: market performance when volatility was low—your father’s volatility—is generally good. Here is a decade-by-decade S&P 500 index performance summary:

Date	Price	Volatility	10-yr ROI	10-yr CAGR	All-time ROI	All-time CAGR
04-Mar-57	44.06	n/a	n/a	n/a	n/a	n/a
03-Mar-67	88.29	0.39	100.39%	7.20%	100.39%	7.20%
04-Mar-77	101.20	0.56	14.62%	1.37%	129.69%	4.25%
04-Mar-87	288.62	0.60	185.20%	11.05%	555.06%	6.47%
04-Mar-97	790.95	0.54	174.05%	10.61%	1695.17%	7.49%
29-Jun-07	1,503.35	0.79	90.07%	6.42%	3312.05%	7.27%
30-Jun-09	919.32	1.48	-33.73%	-16.19%	1986.52%	5.98%

Date = end-date in the time period
Price = final closing price of S&P 500 index for that time period
Volatility = average daily change in absolute value (up or down) of S&P 500 index for the previous ten years
10-yr ROI = total return-on-investment for the previous ten years
10-yr CAGR = compounded annual growth rate for the previous ten years
All-time ROI = return-on-investment since 4 Mar 57
All-time CAGR = compounded annual growth rate since 4 Mar 57

Note that we adjusted the 2007 decade by 90 days to include the last “calm” quarter and isolate the high-volatility quarters into their own decade. And, obviously, the “decade” ending 30 Jun 09 comprises just two years of data.

So, a belated Happy Fathers’ Day to all…and here’s hoping for more of them, volatility-wise, for the rest of 2009 and beyond.