- The recent large swings in the domestic equity market are put into a historical context.
- Volatility this sharp is relatively rare, and concentrated in poorly-performing markets.
- Market environments with swings as large over a similarly short period have tended to be part of broader market sell-offs, on average.
- This article also looks at periods where markets have overcome the exogenous shocks that led to high volatility and managed to post strong equity returns.
Stock markets have been on a roller-coaster ride. What I want to do for Seeking Alpha readers in this article is put this recent volatility in a broader historical context. I want to show what types of returns were generated in market environments with similar volatility. With those historical returns, I want to discuss the types of markets that this virus-induced volatility event might resemble.
Using a daily return series for the S&P 50 (NYSEARCA:SPY) and its predecessor indices dating back to 1928, I calculated the standard deviation of daily returns for rolling 10-day periods. 10 days captures the full seven-day sell-off that began on February 20th. That sell-off included three separate days with losses of greater than 3%. This period also includes two days of greater than 4% returns over the last three sessions.
In the graph below, I show this rolling volatility measure. Since we usually talk about volatility in annualized form, I multiplied the standard deviation of daily returns over 10-day periods by the square root of 252, the average number of trading days in a calendar year. Enough nerd-speak, here is the picture of this volatility metric.
The blue line shows the historical volatility measure. The orange line shows its long-run average. After the last 10 trading sessions, the blue line currently sits at 48.3%, more than triple its long-run average of 14.9%.
You can see the episodic previous peaks where realized volatility has been higher. The debt ceiling debacle, sequestration, the U.S. debt downgrade by the S&P, and the escalation of the Eurozone crisis in 2011 was the last time volatility was this high. Prior to that period it was the 2008-2009 financial crisis.
In this long-run data series, just under 2% of rolling 10-day periods have had higher volatility than the most recent 10-day period. If you shorten the time horizon to the post-World War II period, which de-selects the Great Depression, that figure shrinks to roughly 0.7% of all observations. The last 10-day period in financial markets is one that is going to be talked about for a long time to come.
In this more than 90-year dataset, there have been just 19 previous years that featured such a highly volatile 10-day trading period. In the graph below, I have listed those 19 years and calculated average returns for the S&P stock index.
On average, years that have featured a volatility event as severe as the last 10 trading sessions have delivered negative total returns of -6.4% on average. When you look at just the 9 years post-World War II, stripping out the Depression-era returns, you get a smaller annual loss (-0.4%). As one might expect in a study of volatile market environments, there is a wide dispersion around these average returns with some very strong years and some of the worst years on record included in the sample set.
In those 19 years with volatility events of similar or greater magnitude than the past 10 days, 12 years produced negative returns. Conversely 5 of those years produced annual returns above 25%.
The years with very strong returns include three years that we should categorize as early recovery periods (1933, 1938, and 2009). Those years were bounce-back years from strong sell-offs that accompanied economic recessions. Amidst a historically elongated economic expansion, and coming off a 30%+ annual return for the S&P 500, that is not reminiscent of the current environment.
The other two years - 1997 and 1998 - can be viewed as mid-cycle expansions. For those with a sense of market history, the 1997 volatility was driven by a different type of "Asian flu," the financial crisis emanating out of Southeast Asia that risked spreading to the global financial system. In 1998, the Russian default and collapse of hedge fund Long Term Capital Management led the Federal Reserve to swoop in with emerging monetary policy easing. These efforts, and a continued outperformance of the tech sector, drove strong stock market returns.
What does all this mean for Seeking Alpha investors?
- Periods with realized volatility this high are relatively rare. You should make sure your portfolio is positioned appropriately for your risk tolerance.
- Heightened volatility tends to occur in the contractionary phase or the expansionary phase when the market is having trouble assessing the path forward for economic growth. On average, this level of volatility has been contemporaneously associated with poor equity returns.
- High volatility can also occur from exogenous shocks (war: 1939-1940, the prospect of war 1962, the Asian financial crisis 1997, the Russian default/LTCM collapse 1998).
We could look back at this historic market volatility in 2020 as correctly pricing a contractionary economic environment. We could also look back at this period as extraordinary monetary and fiscal policy, a strong U.S. consumer, and a uniquely buoyant tech sector as delaying a broader stock market correction. I remain in the latter camp at this point, but expect continued volatility as the market vacillates between those two potential paths.
This article was written by
Analyst’s 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.
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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.