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


If we are now seeing a return to more traditional levels, it would be no surprise. According to Dimson, Marsh and Staunton, the important point is that there is no evidence of any significant correlation between levels of volatility and future equity market returns. Spikes in volatility do tend to persist, but most of the impact is over in a matter of weeks, although we should note that the 1987 stock market crash was an outlier – with calm taking several months to re-establish itself.

Greater volatility persisted into March, but you need to be careful not to read too much into its significance. Of course recent events do reflect some short term factors that may signal trouble ahead, including over-confident investor expectations. According to Bank of America Merrill Lynch, the firm’s wealth management clients have increased their holdings of equities to historically high levels in the last few months. When that happens, it is typically a sign that investor confidence has become very high, verging on complacency, and it is often a contrarian signal that share prices have got somewhat ahead of themselves.

To that extent, when markets correct sharply, as they have just done, it can be simply supply and demand coming back into balance. There are clearly plenty of reasons to debate whether from a longer term perspective equities can sustain the strong performance they have put in since 2009. Interest rates are on an upward trend, which is a definite headwind, and valuations are high by historical standards. Central banks have declared their intention to reduce the monetary stimulus which has helped in part to sustain all asset prices since the crisis.

On the other hand company profits have risen strongly in the last 12 months and the global economy is growing – for now at least – more rapidly than in recent years. Technological innovation and other structural changes continue to bear down on inflation, offsetting in part rising inflation expectations. Given these conflicting pressures, asset allocators will as always need cool heads to navigate a successful path through the next few months.

But while it is clearly possible that a new bear market in equities is coming, as some gloomy commentators immediately suggested after February’s market fall, one month’s volatility spike from such very low levels is not in itself – and never has been – a signal of any such thing. Those who tell you otherwise seem to be guilty of market pundits’ favourite sport, which is jumping to conclusions.

About The Author

Jonathan Davis
Jonathan has been analysing and writing about financial markets for more than 35 years, initially as a full-time business ...
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