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    What history says about low volatility

    Synopsis

    The VIX averaged 23 per cent and realised volatility averaged 21 per cent.

    Bloomberg
    For all that's being said and written about the lack of volatility in financial markets these days, you might think something unusual is going on. In fact, history suggests it's the opposite.

    The pattern is pretty clear when one considers realized 30-day volatility for the S&P 500 Index on an annualized basis going back to 1927. Every five years or so volatility rises above 20 percent for a year or two, sometimes getting much higher but usually not, and in between it sweeps out a shallow bowl-like trading pattern that bottoms at about 10 per cent. That seems to be exactly what is happening now.

    Those with sharp eyes might detect that the current volatility lull is a bit deeper than the previous one from 2002 ­ 2006, while it's about the same as the 1990s lull as well as those in the 1950s and 1960s.So, yes, volatility is lower than average historical levels, but it's at levels typical of the bottom of a quiet period between two crises.

    It's hard to tell from the long-term time series just how long before a crisis that market volatility starts increasing. Taking a look at the same chart since 1990 and adding in the CBOE Volatility Index, or VIX, from the beginning of the period 1 one sees that during the internet bubble both realized volatility and the VIX peaked at the end of August 1998, at 42 per cent and 44 per cent, a year and a half before the Nasdaq plunged.

    At the end of January 2000, with the crash still more than a month away, both realized volatility and the VIX were at 25 per cent. Before equities tumbled in 2008 crash, the VIX had poked above 30 per cent in August 2007, more than two months before the stock market peak and more than a year before the financial crisis sparked, in part, by the bankruptcy of Lehman Brothers.

    From the end of July 2007 to the end of July 2008, the VIX averaged 23 per cent and realised volatility averaged 21 per cent.

    The moral? History shows that crises occur when the VIX and realized volatility are above 20 per cent, and investors typically get warned months in advance of what the headlines refer to as "shocks."

    Another way to see the same point is to look at realized 30-day volatility for the S&P 500 on an annualized basis versus the VIX at the beginning of the period. The black line in the graphic below shows the level of volatility predicted by the VIX, so points above the line mean actual volatility ame in above the VIX. You can see hat most of the points are below he line because the VIX overestimates realized volatility.

    But the mportant thing is that there aren't big surprises at low levels of the VIX. Realized volatility has never been above 20 per cent starting from a VIX that is under 12 per cent. And the really high realized volatilities are almost all starting from when the VIX is above 20 per cent.

    The red squares in the chart are the numbers from 2017, showing that both realized volatility and the VIX are at low levels, but not unprecedentedly low levels.

    Looking at what happened in the past starting from these VIX levels, it seems unlikely that we'll get realized volatility above 20 per cent at least over the next month. I'm not claiming a switch to a period of high volatility or a stock market crash is impossible. I'm saying that the evidence provides an argument that dramatic moves are unlikely anytime soon rather than a warning sign of an impending crisis.

    What about all the political turmoil, the populist revolts and terrorism? By and large, the market anticipates news events about 18 months in the future. It's not perfect, of course, but it's a lot better than experts and commentators.

    It's silly to expect today's news headlines to affect today's stock prices in a large way, with the exception of truly unanticipated events such as earthquakes.

    Look at the volatility spike in August 2015. Empirical evidence of the lag between stock market moves and when shifts become obvious to commentators suggests that's about the time the market was worrying about Brexit and Marine Le Pen and Jeremy Corbyn and Donald Trump -perhaps not specifically, but about the political trend that underlies those things -and about other social, political and economic trends pundits are chewing over today.

    The market sorted that out before the first US presidential primary debate, while the news reporters were focused on Ferguson, Missouri; missed debt payments in Greece and Puerto Rico; and whether Marco Rubio could outpoll Jeb Bush for the Republican nomination, with the Democratic process a forgone conclusion.



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    (What's moving Sensex and Nifty Track latest market news, stock tips and expert advice, on ETMarkets. Also, ETMarkets.com is now on Telegram. For fastest news alerts on financial markets, investment strategies and stocks alerts, subscribe to our Telegram feeds .)

    Download The Economic Times News App to get Daily Market Updates & Live Business News.

    Subscribe to The Economic Times Prime and read the Economic Times ePaper Online.and Sensex Today.

    Top Trending Stocks: SBI Share Price, Axis Bank Share Price, HDFC Bank Share Price, Infosys Share Price, Wipro Share Price, NTPC Share Price

    ...more
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