Stay calm: Volatility readings are still pretty low

The U.S. stock market, where the S&P 500 Index (SPX) has closed at record highs 17 times this year, is experiencing choppy price swings of late, keyed to the day-to-day market speculation about when the Fed might reverse its ultra-loose monetary policy. The Nikkei 225 Average (NKY), up more than 40% on the year  in mid-May, has fallen about 17% since then, and is now technically in a correction.
^SPX Chart

^SPX data by YCharts

Meanwhile, the U.S bond market has hit some turbulence and home mortgage rates are now approaching 4%. So the big question of the moment is whether market volatility, nowhere to be seen most of this year, is starting to make a comeback. The quick answer is yes: volatility in some markets is up—but not so dramatically compared to historical averages and certainly not at the levels of the high anxiety days of the 2008 financial crisis.

A review of the key volatility metrics by Bloomberg – which technical analysts track – suggests that historic monetary easing by the world’s major central banks is keeping market instability and price swings at a reasonable level, despite the recent headlines. Here’s a quick recap of Bloomberg’s findings:

1) Volatility levels in the in equities, commodities, bonds and currencies tracked by the Bank of America Corp.’s Market Risk index has risen some from a five-year low set back in January. Even so, the gauge remains about 75 percent below average readings over the past 13 years.

2) The Chicago Board Options Exchange Volatility Index shot up 30 percent in the last two weeks of May, but remains 14 percent below its historical average and is still down from elevated levels back in January.

VIX Chart

VIX data by YCharts

3) Bank of America Merrill Lynch’s MOVE Index, which measures volatility based on prices of over-the-counter options on Treasuries maturing in two to 30 years, is still well below the average reading going back to the start of 2007.

4) A closely-watch price swing gauge followed by traders, the S&P’s GSCI Spot index of 24 commodities, is down 77% since its all-time high set back in late 2008.

Whether this is good news or bad depends on your point of view. There’s a very interesting debate at the moment among finance academics and stock market investors about whether volatility creates investing opportunities or not.

According to a report (.pdf) by Wells Capital Management published earlier this year, the market has seen long stretches– between 1992 and 1996, or between 2003 and 2007—when stocks performed well yet volatility was relatively low. That’s pretty much the case now.

Back in 2011, Brendan Bradley of Acadian Asset Management, along with Harvard’s Malcolm Baker and NYU’s Jeffrey Wurgler, published a widely cited study in the Financial Analysts Journal on the returns of low-volatility stocks. (Here’s a direct link to the study.) According to their research, the least-volatile quintile of the 1,000 biggest stocks in the U.S. returned 10.2% annually from 1968 to 2010. In contrast, the most-volatile quintile gained just 6.6%. Check out my post from earlier this year for more details on this debate.

If you are intrigued by volatility-based trading strategies, check out:

  • LakeView’s High Dividend, Low Volatility model, which holds stocks and ETFs that produce above-market average dividends while exhibiting below-market average volatility.
  • Robert Zingale’s Covestor Volatility Mean Reversion model. In his latest commentary, Robert outlines his trading strategy in the months ahead.