Volatility Is Dead, Long Live Volatility?

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL-OLD, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV, VXX
by: Giesbers Investment Strategy

Summary

The largest drawdown in the S&P 500 was only -2.8% in 2017.

This was the second-lowest maximum drawdown since 1928, trailing only the year 1995.

The average daily change in the S&P 500 also was the second-lowest in history.

In this article, I will look at past performances of the market in time periods with very low volatility.

2017 has been a very smooth year for most equity markets worldwide, including the S&P 500 (SPY). As can be seen in the picture below, the maximum drawdown of this index was only -2.8%. This was the second-lowest percentage since 1928.

drawdowns

Source: Charlie Bilello

The years of 1954, 1958, 1961, 1964 and 1995 were the only other years when the maximum drawdown was less than 5%. During the '50s and early '60s, there were a couple of years with very low drawdown, but most notably, the '90s were characterized by a long period of low maximum intra-year drawdowns of the market.

Inspecting the average daily drawdown of the S&P 500 shows almost the same picture:

volatility

Source: Bloomberg, FT research

This data also correlates with the level of the VIX (VXX) of the S&P 500:

Chart ^VIX data by YCharts

During the year 2017, a buy-the-dip investing strategy of the S&P 500 was not really possible, since there were no real dips to speak of. Of course, not all stocks have moved in the same direction as the broad market, but overall, 2017 was a very quiet year for volatility.

bullbear

Source: First Trust Advisors

When we look at other time periods with very low volatility and drawdowns and compare these periods with an overview of past bull and bear markets, the following observations can be made:

'50s and early '60s: During these years, the S&P 500 experienced a nice bull market, which was interrupted by a brief bear market of -22.3%. After the year with the lowest drawdown in this time period, 1964, volatility increased again. This increase in volatility preceded the two other bear markets in the late '60s and early '70s.

'90s: Volatility was at a very low level for a long time in the '90s. The maximum drawdown in a year, the average daily drawdown and the VIX all showed very low numbers, and the stock market experienced one of its greatest rallies ever. At the end of the '90s during the dot-com bubble, volatility started increasing again and preluded the bear market which would later follow.

'00s: Volatility was relatively low from 2004 until 2007, but then quickly and dramatically increased into the Great Recession.

When looking at these periods of time, it is apparent that volatility can stay low for a long time. In 2017, the maximum drawdown and the VIX might have been among the lowest in history, but that does not mean investors can expect a more dynamic market situation shortly. In the '90s, increasing volatility preluded a bear market, but the data from the '50s and '60s show a much more distorted picture. In the '00s, the bear market arrived suddenly with very little increase in volatility beforehand.

The current period of low volatility has been long, but not extraordinarily long when we look at the historical data. Though it would seem logical to expect it to return to the mean somewhere in the future, I would not be surprised if this situation of low volatility still continues for quite some time.

For buy-and-hold investors who are looking for dips, this means two things: First, it is very uncertain whether huge dips will arrive in the near future. Thus, I would be reluctant to wait for such market corrections. Second, by not investing in this market, investors might be missing out on huge gains. Instead of waiting for a correction, it might be prudent to carefully increase your positions if you have dry powder. To execute such a strategy, I am a huge proponent of dollar cost averaging.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.