Volatility returned to the equity markets in February after an extended period of unusually low levels
While the exaggerated swings in equity markets are disconcerting, they are likely a result of investors grappling with too much complacency, rather than a reflection of any negative turn in the economy or fundamentals
Company earnings continue to show strength which is supportive of equity markets going forward
The return of volatility could be a boon for active managers, who have been challenged by its absence in recent years
Investors took solace in the lack of stock market volatility in 2017. In reality, that may have been more of an anomaly than the current turbulence equity investors are experiencing. Volatility spikes in the capital markets are not unusual. Similar occurrences have happened throughout the bull market recovery since the “Great Recession”, most notably the “Flash Crash” of May 2010, the “Summer of Volatility” in 2011, and the “Brexit Fears” in June 2016. Entering 2018, stock market volatility was unusually low for several months and years. The S&P 500 Index five-year rolling volatility declined to less than 10 percent and during 2017 it was less than four percent, versus 25 year average volatility that was closer to 13 percent. This abruptly changed last week. A portion of the blame for the selloff came from signs that the U.S. is returning to a normal economic cycle, whereby stronger growth and earnings are likely to spark a modest pickup in inflation and the Fed-induced responding with higher interest rates. Added to this is concern about increased pressure coming from aggressive Fiscal stimulus late in the cycle. However, the hidden culprit could have been the reversal of too much complacency, with market participants finally recognizing that the extended period of extremely low volatility is being replaced by a return to the “old normal.”
For 2017, the S&P 500 Index completed a 12-month period of consecutive monthly positive total returns for the first time since 1950 – 67 years. Likewise, downside deviations in the stock market were limited as the S&P 500 Index did not post a two percent down day during the year, versus what would typically be seven or eight two percent down days in a year. This abruptly changed in early February 2018.
The VIX index was below 10 in mid-January and gradually rose to the low teens at the end of January. On Friday, February 2, the S&P 500 Index ended its longest streak on record without a three percent correction and by February 5, the S&P 500 Index declined five percent below its recent peak for the first time since the Brexit fears in June 2016. Ultimately, the VIX spiked to 50+ at a time when many market participants had become anesthetized to the low volatility registered the last several years. The surge in the VIX was remarkably consistent with previous sell-offs of this magnitude, notwithstanding 2008/2009 when the “Great Recession” unfolded. Even so, the rise in volatility fueled waves of selling last week in part due to margin calls to cover short volatility positions in the equity market and risk parity strategy adjustments. The partial rebound in stocks late last week, after testing the long term 200-day moving average support, and the slight moderation in volatility could be a sign that the worst of the pullback is behind us.
Where do we go from here?
Despite the recent events, a rebound in economic activity and earnings, combined with a back-up in market interest rates and inflation for the “right” reasons (including strong demand and wages going up as a result of improved corporate profits), suggest that the period of a highly accommodative monetary stance is likely to come to an end in 2018. Similarly favorable macroeconomic conditions unfolding in Europe and Asia show that the period of benign central bank policies is likely to change outside the United States this year as well. This should help to hasten the transition from a gallop to a grind that we wrote about in January.
At the end of 2017, one-year volatility for equities was less than one-half (and for several asset classes less than one-third) the volatility experienced during the last 25 years. The abrupt change in volatility in early February has been challenging; however, an important factor that historically drives equity returns, earnings, remains extremely positive. With about 68 percent of the S&P 500 companies reporting, more than 81 percent are beating estimates, with yearly earnings accelerating at a robust 15+ percent pace.
Looking forward, solid economic growth and the reduction in corporate tax rates is likely to provide an 18 to 20 percent increase in earnings in 2018. Thus, the S&P 500 Index appears to be trading at less than 17 times 2018 earnings. This is above the historical average of 15.7, but the higher valuation may be justified by the record amount of cash on corporate balance sheets, the likely repatriation of billions from overseas corporate profits, and the extremely low returns from U.S Treasuries. Moreover, corporations may use the current period of market indigestion as an opportunity to initiate stock buybacks with repatriated foreign earnings.
Active Management Benefits from Higher Volatility
Low levels of volatility are generally supportive of broad equity and credit market returns but can often be a headwind for active equity managers seeking to take advantage of security specific pricing inefficiencies. Conversely, slightly higher levels of volatility may expand opportunities for active stock pickers but often in a lower overall return environment due to the likely moderation in P/E multiples. We recognize that the events that unfolded at the start of this month may represent the beginning of a move to higher volatility than what has been experienced over the past year as interest rates, inflation, and economic conditions normalize. Nonetheless, we are somewhat encouraged that the VIX index tempered to less than 30 at the end of last week. And, as the spike in volatility continues to moderate towards the long term volatility experienced over the last 25 years, the equity market should rebound and return to producing more singles and doubles, rather than the either the waterfall selloff of the last week or the homeruns of the past two years.
 The Chicago Board Options Exchange Volatility Index reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes.