Should We Be Concerned about Economic Volatility?

I recently came across some interesting research on volatility, written by BlackRock’s Global Chief Investment Strategist, Russ Koesterich.

His note — appropriately titled “Welcome Back, Volatility” — serves as a level-headed warning to investors… reminding us that markets are likely to become more volatile as the Federal Reserve works to adjust its monetary policy, after years of unprecedented stimulus.

I’ve reproduced the chart in Koesterich’s note, which shows the number of days the S&P 500 made a daily gain greater than 1% (in green) and the number of days the index lost more than 1% (in red). Take a look…

AOTC April

The idea is that by counting the number of days that the stock market has made a move greater than 1% (either up or down), you have a reasonable proxy for the level of volatility in the market.

You’ll quickly see that this measure of volatility declined from 2009 through 2014. In fact, there were 68% fewer “volatile” days in 2014, relative to the 118 volatile days in 2009.

There’s a reason for that. As Koesterich explains, the Fed’s monetary policies essentially pressured volatility lower, encouraging investors to play the markets with greater risk.

But volatility tends to be mean-reverting…

Generally speaking, periods of heightened/rising volatility are followed by periods of low/declining volatility, and vice versa. So after five years of declining volatility… we’re “due,” so to speak, for a period of rising volatility

And it seems that 2015 is on track to, as Koesterich put it, “welcome back” that volatility. If the year-to-date pattern holds, we can expect to see about 79 volatile days this year — far more than we experienced in 2012, 2013 and 2014.

That means you should be really worried, right? Well, not so fast…

If you look at the chart above, you’ll notice that the S&P 500’s returns don’t necessarily relate to the level of volatility in any particular year.

For instance, 2013 and 2014 look nearly identical when judged by their number of volatile days, but stocks gained nearly 30% in 2013… and only 11.4% in 2014.

This means that, in my eyes, our expectations of rising volatility have very little predictive power in determining how the S&P 500 might end the year.

Passive investors will simply have to hold and hope… hope that this year’s volatility pushes stocks 13% higher (as it did in 2010)… and NOT cause year-to-date returns to evaporate (as it did in 2011).

Of course, buy-and-hold-and-hold-on-for-dear-life isn’t your only option, and it certainly isn’t your best one either in the face of rising volatility.

Next week… I’ll continue this discussion of volatility and show you how actively-managed strategies actually thrive in these environments.

Adam-ODell2
Adam

 

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Categories: Economy

About Author

Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.