Jonathan Davis MCSI is an independent investment strategist and an outside member of Saunderson House’s investment committee. His views are his own and are not necessarily shared by Saunderson House.
When financial markets make sharp or sudden moves, as they did last month, it is natural that people wonder whether that movement is telling us that something important has happened – or at least is about to. Sometimes that is the case. Yet experience shows that this is far less common than you might think, or media headlines typically imply. The dull reality is that the fundamentals which drive investment returns, such as company earnings, the rate of inflation and interest rates, change far less rapidly than short term movements in financial markets suggest.
One reason that what happened in February grabbed the headlines is that it followed a long period of benign, bordering on comatose, tranquility. The S&P 500 index, which measures the performance of the largest equity market in the world, had risen for a near unprecedented 15 months in a row before February’s decline. To adopt the language of the markets, we have been living through a long and unusual period of low equity market volatility.
Yet last month that changed. Stock markets sold off sharply. The S&P 500 index fell by 10% in just ten days before recovering about half of those losses by the end of the month. The UK’s FTSE All-Share index also suffered, declining by 7% in the early days of February. Only a handful of emerging markets were able to buck the downward trend and finish the month of February higher than they started.
You can see this change in market behaviour quite clearly from Fig.1, which tracks the performance of the VIX, or volatility index, since the start of 2017. The VIX is a calculation of implied equity market volatility, derived from option prices. Although designed originally as a measurement tool, it did not take long for investment banks to realise that it could form the basis of a whole class of financial derivatives to enable professional and retail investors to place bets on its future direction.
Fig. 1 Volatility Index (VIX) – since the start of 2017
Thousands of investors of all kinds have been doing just that. Betting that volatility would remain low had become a highly profitable trade, so much so that many traders have been piling on leverage – borrowing to fund their bet – in the hope of magnifying what had become seemingly surefire repeatable gains. One popular way was to buy a leveraged exchange-traded fund that moved up and down inversely with the movement in volatility: the lower the VIX, the more it paid out, and vice versa.
In February, those who were positioned to profit from continued calm got burnt when the volatility index suddenly spiked. Two of the largest exchange-traded funds that offered investors a chance to profit from low volatility were closed by their investment bank promoters after the leverage kicked in, leaving those who owned them nursing losses running in aggregate into billions of dollars.
What, though, does that tell us about the prospects for future investment returns? In itself very little. It mainly tells us about the risks inherent in leverage. The longer an apparently winning strategy persists in financial markets, the more speculators are drawn to it – and the more likely in turn it becomes that borrowed money will be used to fund their transactions. Experience suggests that profit-seeking professionals are just as vulnerable to the temptation of leverage as naïve private investors. The collapse of Long Term Capital Management in 1998 provides a classic case history.
A second, more important point is that volatility has historically been higher than it has been over the last few years. The second chart (Fig. 2) gives a longer perspective on how equity market volatility has behaved since 1990. As you can see, until February’s spike, recent levels have been significantly below the long term average (which is around 19%). From this perspective it is the calm, not the volatility, that has been the outlier.
Fig. 2 Volatility Index (VIX) – since 1990
During February, the S&P 500 index moved up or down by more than 1% in a day twelve times, this was more than the whole of 2017. The change needs to be kept in perspective. Before the global financial crisis such moves were far more common (Fig. 3) – something that investors used to take in their stride as the price for taking the added risk of investing in stocks. Nevertheless the February spike in volatility was the tenth sharpest since 1986, according to Professors Elroy Dimson, Paul Marsh and Mike Staunton, authors of the authoritative Global Investment Returns Yearbook, which analyses market returns since the early twentieth century.
Fig. 3 S&P 500 Index Daily Price Moves
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