Market volatility has been at the forefront of investors’ minds for at least the past three years. While we have seen generally low volatility in the U.S. stock market during this period, specific shorter periods have been marked by severe volatility spikes, most recently in August 2015 and February 2018. These spikes have coincided with waterfall declines in stock prices even as the bull market has raged on. Whatever the reasons for these volatility dynamics, it can hardly be doubted that these volatility extremes have changed investors’ expectations and beliefs about what qualifies as normal market behavior. This includes the recent sharp—but as yet ordinary—declines in October 2018.
Market volatility regimes tend to revert to the mean, and this mean reversion exists on every time frame, even over decades. In the words of many, the bull market that began in 2009 has been the “most hated” in market history. To the extent that this is true for investors, it’s likely no accident that the bear market from 2007-2009 that preceded this bull was the worst since the Great Depression, not to mention the fact that another bear market, almost as severe, had occurred less than one decade before that, from 2000-2002. The recent past drives our perspectives of the present. We are always fighting the last war.
In retrospect, it’s fitting that the bull market that began in March 2009 continues to this day without any such extreme drawdowns, and with generally low volatility. On every time frame, periods of higher volatility are followed by periods of lower volatility and vice versa. The same principal that creates fear and loathing at one moment denies them in the next. The market is the great mean-reverting system.
Despite the significant degree to which this bull market has been hated, optimism has found its way into the market since Brexit and the U.S. presidential election in 2016. Immediately after both elections, stocks around the world rallied strongly. It wasn’t until the volatility spike in February 2018 that their momentum was stopped. During this roughly eighteen-month time frame, stocks enjoyed remarkably low volatility and a stair-step route to higher prices.
But this low volatility regime caught many off-guard when higher volatility inevitably reared its head in February 2018. Those who betted continuously on lower volatility “blew up” their accounts literally overnight when volatility reverted backward. The inverse volatility exchange-traded note XIV was shut down after the fund lost greater than 80% of its value in one day, and several hedge funds, like LJM Partners, went out of business.
My claim in this post is that investors have finally grown accustomed to the low volatility environment that has dominated the markets in the past few years, and have even come to expect it, but without anticipating the inevitable volatility spikes that must occur from time to time in such a regime. In doing so, investors are mistaking historically normal market action currently, even for this bull market, for a fearful sign of things to come. But while the recent drawdown is not over, there is every reason now to doubt that a new bear market has begun.
Ryan Detrick of LPL Research has produced a wealth of relevant data on recent market action. One such data point indicates, once again, how the period preceding the recent surge in volatility was a period of extremely low volatility. For 74 consecutive days, the S&P500 index neither advanced nor declined more than 1% in any one day. That’s simply extraordinary. As a result, it can hardly be surprising that a surprisingly long period of market quiet would end with a volatility surge and lower prices occurring suddenly. Add to this the fact that October is typically the most volatile month of the year for stocks, particularly so before midterm elections, and you have the factors in place for a fairly routine market decline.
What about the extent of the decline in stock prices? Has the market wounded us with a sharp drawdown? Not really. Charlie Bilello of Pension Partners has indicated that the current market correction is fairly ordinary by the standards of this bull market.
Of course, this correction could get worse, even much worse. But the likely reason investors are worried about it has less to do with market history or statistics and much more to do with beliefs and expectations. My suspicion is that investors’ beliefs and expectations about this market correction derive from the abnormally low volatility in the period that preceded it. If you are used to only slight changes in the value of your account on a day to day basis, a 1-3% move in a day can catch you off guard. The great irony of recent volatility surges is that just ten years ago volatility was through the roof during the worst days of the Great Recession, and not just for a few days or a few weeks, but for months, and with severe drawdowns to boot.
So, investors should let the evidence drive their expectations, particularly this unique volatility regime. There are no guarantees that the recent correction does not morph into a more severe correction, or even a true bear market bringing even worse declines. But the probabilities do not favor it. Investors should be prepared for a bear market, but they would do themselves a disservice not to imagine that the bull market will continue to reach new highs.