VOLATILITY IN TRANSITION
In this piece, we will examine prior transition periods from low-volatility to high-volatility regimes and compare such periods to our current markets. We will then answer the question: Are we transitioning from a prolonged low-volatility to a prolonged high-volatility regime?
Realized Volatility Since 1950
Since 1950, Realized Volatility (as defined as the rolling 12-month standard deviation of returns of the S&P 500) has bottomed seven times: 1959, 1964, 1972, 1984, 1995, 2007, and most recently in 2017.
On average, 41 months following these bottoming periods, Realized Volatility subsequently spiked into its 90th percentile in 1962, 1970, 1974, 1987, 1998, 2008, and most recently to-be-determined.
The table below shows the dates and values associated with the above commentary:
The above analysis shows that, on average (including the two "W" volatility bottoms of 1993-95 and 2004-07), the time between these troughs and spikes was 41 months. The average increase in Realized Volatility was from 5.9% to 21.1%.
Of note are potentially three key similarities between Periods 5 and 6 with current volatility regime (Period 7):
1. In Periods 5-7, volatility made a "W"-shaped bottom
2. In Periods 5-7 the trough occurred during the middle of a Fed hiking cycle
3. In Periods 5-6, the spike higher in volatility occurred at or near the end of that hiking cycle
Given the recent comments by our Fed Governors, such characteristics resonate with our current Period 7.
Although the time of elevated Realized Volatility in Period 5 included all-time market highs, the time of elevated Realized Volatility during Period 6 coincided with the financial crisis. Therefore, market direction does not always correlate to the direction of volatility. Both "bull" and "bear" markets can experience similar levels of Realized Volatility. To be sure, from August 1998 (the first month to reach the 90th percentile in Period 5) to August 2000 (the high in the S&P 500), the S&P 500 rallied approximately 60%. Yet, over that same period, 11 of the 24 months included Realized Volatility in the 80th
We are in the 39th month of our current low-volatility trough and have begun to accelerate higher during 2018. In March 2018, Realized Volatility reached into the 8-9% range. By November, that figure had accelerated into the 12-13% of Realized Volatility range.
Over the last five years, market participants have been experiencing a prolonged low-volatility regime in which they may have grown accustomed to relatively low monthly swings in the S&P 500. Characteristic of the bottom quartile of Realized Volatility, the S&P 500 has primarily had monthly returns typically ranging from +/- 3%. As we have transitioned into 2018, Realized Volatility has moved into the second quartile, or an environment in which monthly returns in the S&P 500 typically range from +/- 5%. Should markets follow historical patterns and continue to march toward the top quartile of monthly returns, market participants should be prepared to endure market swings of upwards +/- 10-20%.
VIX Levels and Trends in Transition
Observing the behavior of the VIX Index since 1990, one can remark on several characteristics (reference the below points with the chart below):
1. The VIX Level around 16-17 is a critical historical level for both support and resistance (blue horizontal line)
2. An upward trend in the VIX ushers in the transition to a higher-volatility regime (blue trend-lines)
3. The upward trend usually carries with it an initial spike (red circles), a retest of the trend-line (red arrows), and then a move higher into a new regime
4. Once established above or below the 16-17 range, VIX congregates above or below the historical support/resistance line for an extended period of time (gold horizontal lines)
In taking a closer look into the similarities between the 2008 and present periods in the VIX Front-Month Futures, we see the same dynamics at play: a respect in the 16-17 support/resistance line, a trend upward initiated by a spike and followed by a retest of the support line.
None of the above should be construed as a forecast that we are indeed transitioning into a higher volatility regime. If any statement is true about markets it is that they behave in their own way and in their own time. That said, the patterns are clear that moves into the lower percentiles of Realized Volatility have historically produced sharp snap-backs into higher-percentile volatility regimes. We are in the 35th month (averaging time since the May 2013 and Nov 2017 troughs) since the bottom of our latest Realized Volatility period. On average, it has taken Realized Volatility approximately 41 months to then make a move into its 90th percentile. As a warning, the late 1990s has taught us that increased volatility does NOT necessarily mean bear markets! The S&P 500 has made both all-time highs as well as catastrophic bear markets in the context of higher volatility regimes.
In addition to the analysis of Realized Volatility regimes, understanding how the VIX Index and VIX Front-Month Futures transition can help put additional context around inflection points. It would seem that both the VIX Index and VIX Front-Month Futures are telegraphing a potential move into a higher-volatility regime–marked by the pattern of the initial spike off the trough, a retest of the historically significant resistance/support levels, and lastly followed by a move higher.
Given the above data and analysis, a higher-than-normal probability exists that we are in the midst of a prelude to a higher volatility regime regardless of the direction of the S&P 500.