The last several years have featured tremendous realized volatility for global equity markets. The global financial crisis, European sovereign debt crisis and Grexit, the U.S. debt ceiling standoff and S&P downgrade, and Chinese economic deceleration have all been market risk flares. Are there features of the macroeconomy and capital markets that are leading to a structural uptick in equity volatility rather than a cyclical upturn in volatility driven by the economic recession? After all, this equity market volatility has occurred in an economic expansion. While this recovery has been meager, volatility suppression from extraordinary monetary accommodation, which has arrested some of the downside in domestic equities, should have led to more stable returns. If equity volatility and risk are indeed increasing, but expected forward returns remain subpar given muted global economic growth and relatively high equity multiples, are equities a worsening proposition for investors?
To construct the chart below, I examined daily returns of the S&P 500 (NYSEARCA:SPY) index from its move to five-hundred constituents in 1957 through the current market close. The chart graphs the annualized standard deviation of daily returns over the trailing 252 trading days (approximately one-year). The results are graphed with a linear trendline that shows that equity volatility has been rising on average over time. What are some of the reasons for this change, and do they have meaningful implications for the management of your portfolio?
Source: Standard and Poor's; Author's Calculations
Equity volatility is countercyclical, rising in business cycle downturns as stock markets fall. To see this, examine the spikes in the most recent recessions and the volatility void during the 1990s expansion. Adjusting for these inherent swings in realized volatility driven by the business cycle, there is still a structural uptrend. Equity volatility, as seen above, continues to make both higher peaks in times of market stress and higher lows in times of relative market calm. Below is a discussion of some of the drivers behind this phenomenon.
Macroeconomy - Since equity volatility is related to macroeconomic volatility, some might contend that as leverage has increased in the U.S. economy (especially in the government and household sectors) that equity volatility should be increasing as well. I would counter that debt-to-GDP in the United States was around 50% at the start of the data set in 1957 as the U.S. economy continued to de-lever from World War II, and did not cross through this threshold again until the most recent financial crisis (when it zoomed past that figure). Equity volatility also rose in the late 1990s when the federal government was running budget surpluses. While macroeconomic volatility and equity volatility are undoubtedly related, it is a cyclical and not structural linkage.
Index Trading - As passively managed index funds and exchange traded funds have blossomed over the past quarter century, trading commonality and equity correlations have increased. Research by Rodney Sullivan and James Xiong published in the Financial Analysts Journal suggested that the increased correlation from index trading is an important characteristic in the increase in systematic risk. This has important consequences for equity investors. An increase in systematic risk is reflected in the rising equity volatility and also limits the gains to diversification. The pair demonstrated that diversification benefits of equity investing have decreased for all styles of stock portfolios independent of capitalization or style. The graph below shows that S&P 500 member stocks have had higher cross correlations than non-member stocks, but that cross-correlations had been rising for both groups over time.
Average Cross Correlations between Absolute Volume Changes and Absolute Price Changes for S&P 500 Stocks and Non-S&P 500 Stocks
Source: "How Index Trading Increases Market Vulnerability"
High-Frequency Trading - Frank Zhang of Yale University School of Management demonstrated that high-frequency trading is positively correlated with stock price volatility, and the rise of these trading programs over the past several decades has likely increased market volatility. By his estimates, high-frequency accounted for 78% of total volume in the first half of 2009, and has driven total share turnover per quarter to over 100% from its generational average of around 20%. The author points to three reasons why high-frequency trading could increase equity volatility. In the May 2010 "Flash Crash" high trading volume proved to be an unreliable indicator of market liquidity. If fundamental investors were using trading volume as a proxy for liquidity on that day, then they were misled in what turned out to be a very shallow market. Secondly, algorithmic-based trading often is based on short-term statistical correlations among stock returns and can create self-reinforcing momentum that exacerbates market moves. Third, high-frequency traders seek to front-run large institutional orders by co-locating their computers physically closer to those of the exchange, a technique that drives volume and volatility.
Percentage of High-frequency Trading in Total Trade Volume ('54-'09)
Source: "High-Frequency Trading, Stock Volatility, and Price Discovery"
Market volatility will always be cyclical in nature, but is there a structural element to the long-run rise in volatility that we have seen? Equity volatility's trend higher appears unabated and increased index offerings, the increase in popularity of leveraged index funds and rise of high-frequency trading could continue to drive volatility higher. If equity volatility is higher and rising, should investors demand higher returns for the elevated risk? Instead of demanding higher returns, equity multiples are actually above long-run averages, suggesting lower forward returns. Has increased risk in domestic equities increased demand for fixed income securities that have driven yields to historic lows? Are heightened equity multiples justified by these historically low bond yields? Should my preferred low volatility stocks command even higher premia given the rise in equity market volatility?
I do not have decisive answers to these questions, but this forum should provide an avenue to debate the data distilled herein. I present the data here as a high level thought piece about how the market is evolving, and the implications for investor asset allocation and portfolio management. Feedback and thoughtful discussion are very welcome.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term, risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.
Disclosure: I am/we are long SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.