The last several years have featured tremendous realized volatility for global equity markets. 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? If equity volatility and risk is increasing, but expected returns remain low given muted global economic growth and systematic de-leveraging of the financial and government sectors, then are equities a worsening proposition for investors?
To construct the chart below, I examined daily returns of the S&P 500 (SPY, IVV) index from its advent 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 your portfolio management?
Equity volatility is countercyclical, rising in business cycle downturns as stock markets fall. 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% 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. 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 twenty years, trading commonality and equity correlations have increased. Research by Rodney Sullivan and James Xiong published in the Financial Analysts Journal suggests 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.
Source: "How Index Trading Increases Market Vulnerability"
High Frequency Trading - Frank Zhang of Yale University School of Management demonstrates 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. High frequency trading by his estimates 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.
(click to enlarge)
Percentage of High Frequency Trading in Total Trade Volume ('54-'09)
Source: "High-Frequency Trading, Stock Volatility, and Price Discovery"
If equity volatility is higher and rising, investors should demand higher returns for the elevated risk, which might partially explain why interest rate adjusted earnings multiples remain well below historical levels. Rising equity volatility could be causing a negative feedback loop through the real economy given the effects on consumer wealth. Equity volatility's trend higher appears unabated, and increased index offerings and the increase in popularity of leveraged index funds could continue to drive volatility higher. Does increased risk in domestic equities increase demand for fixed income securities despite the seemingly unfavorable relative valuation of the latter?
I present the data here as a high level though piece about how the market is evolving, and the implications for investor asset allocation and portfolio management. Feedback and thoughtful discussion is very welcome.