In this paper, we will update multiple analyses that we first shared in our original paper "Volatility in Transition". It is our opinion that volatility has completed its transition and that we have now entered into the higher part of the volatility cycle. In other words, instead of reverting to levels seen from 2004 to 2007 or from 2013 to 2019, volatility will likely cluster in areas similar to periods like 1998 to 2003 and from 2007 to 2012. The ramifications for markets during high volatility regimes are characterized by above–average monthly moves, greater uncertainty, and opportunity. With greater uncertainty comes the potential for dangerous credit shocks (i.e. Russian debt crisis, global financial crisis) bubble bursts (i.e. technology, housing), and revelations of malfeasance which strain confidence in economic systems (i.e. accounting scandals, investment fraud, and lending practices).
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 in 2020, assuming markets close March where they currently are or lower.
The chart above shows the cycles of transition from periods of low volatility, which typically last years, to periods of high volatility, which also typically last years. The blue-shaded region shows the transition that has transpired since our original publication on this topic. Since that time, volatility continued to rise and came just short of achieving the 90th percentile. If markets close March where they currently are or lower, volatility will have achieved the 90th percentile and completed its transition.
The evidence of cycles is also observed in the below chart. We can see the clear delineations between the low and high volatility regimes. Volatility clusters. For multiple years, volatility will concentrate around lower levels, transition, and then traverse through a higher median. Given the clear bottom which formed in 2017, the base formed and maintained through 2019, and the solid launch into the higher cycle (level shown as of the end of February 2020), we believe the transition pattern that has occurred in previous periods is now complete. With continued advances of volatility into March (not shown), the confirmation to the higher end of the cycle is all but certain. We therefore expect, just as in previous high volatility cycles, a VIX level of greater than 15 for a significant period of time. To be sure, the VIX will likely track within the 20-40 levels for most of the time while volatility remains elevated.
In terms of comparison to other volatility cycles, we compare the current COVID-19 crash (as of March 13, 2020) to four other market sell-offs: Great Depression, ’87 Crash, Dotcom bust, and Great Recession. To create a fair comparison, we show the first 370 days of each sell-off side-by-side, starting from each period’s market peak. The speed at which the COVID-19 crash has ensued is staggering.
Below is also the table format for the data based on market conditions of each market episode, 17 days from the market peak which confirms the speed of the COVID-19 crash.
As we can see from the above charts, the COVID-19 crash has the fastest decline from a market peak. More alarming is the trajectory of realized volatility as it tracks the steepness of the Great Depression and the ’87 Crash. This kind of volatility portends economic pain. The angle of the increase indicates market participants collectively believe the economic stall from the COVID-19 virus is extremely concerning to the health of the overall global economy.
Further supporting the thesis that volatility has transitioned, we present the trifecta of developments which ratify the regime shift. Namely, the Federal Reserve cuts rates, the yield curve inverts, and volatility reaches the 90th percentile.
Going back to 1976, we can see that all three of the factors we mention above occur close together. Furthermore, in each of the above cases, a recession also ensues.
While a transition to higher volatility does not, in and of itself, correspond to recessions, we believe in this case it does. In each of the last four recessions, a bubble had emerged and popped. However, in each of the preceding four recessions, the bubbles were progressively coterminous to the broader economy. In the early 90s, the bubble was the Savings and Loan Crisis. In 2000, the larger dotcom bubble enveloped the entire technology sector. In 2008, the global housing bubble threatened to take down the global economy. In 2020-2021, we believe a sovereign nation or nations will cause widespread economic failure.
In each of the preceding recessions, the scale and scope of the malinvestment grew larger. The adage goes that the seeds sown in each recovery are the fruits of the next recession. For example, to combat the dotcom bust, the Greenspan Fed and other central banks kept rates too low for too long, incentivizing consumers and banks to borrow and lend beyond the means of either party to withstand a pullback in real estate prices.
In the here and now, a multi-pronged bubble emerged in the wake of global rates staying at or below zero for multiple years. Among the beneficiaries of easy money include the Chinese banking system, debt-laden corporations, and the present equity markets which were propelled by corporate share buybacks.
The COVID-19 virus has brought areas of the global economy to a near standstill. Airline and travel industries have grinded to a halt. Restaurants and other consumer-led businesses have emptied. Energy markets currently reflect the deflationary pressures of economies and trade scaling back. These slowdowns in economies do not occur within vacuums. Certainly, most economies can absorb minor shocks and blows as they charge forward. However, in each recessionary case, a tipping point is reached and the knock-on effect moves from industry-specific pain to widespread collapse.
Since 2008, the Chinese banking system has grown faster than banking systems in any other global economy. While the Chinese government may intervene to force term extensions and conduct capital infusions, the problem will be bigger than what they are able to manage. On the home front, we documented in our paper "Crash or Consolidation" that the market had risen considerably more than corporate profits. Fueled by an increase in corporate debt from $3.7T at the end of 2009 to $6.6T currently, corporations have engaged in a share buyback frenzy which has pushed markets beyond the support of their core earnings. As share buybacks abate, market liquidity will decline and markets will continue to suffer. A relief rally may occur in the medium term as fears subside or as patients recover, but likely the longer the economy endures a pause merely increases the risk of longer-term damage. That damage would likely emerge in the form of layoffs and defaults, further exacerbating economies which have layered on debt since 2008 and which have mounting obligations to an ever-burgeoning retirement class. The real fear we will face is whether a total collapse of the system will occur or not. In that sort of panic, it is hard to imagine where markets will trade and how fast that fear will distill in the minds of market participants.
Therefore, the economic crisis of this age will be characterized by the threat of collapse of sovereign nations and economic systems. The adage that sharp moves occur in the direction of trends also applies to politics and nations. Populism and self-determination have taken hold across the western world and in parts of Asia. As economies come to the brink, populations will push those trends toward radical change of the status quo.
Volatility has transitioned. The new normal over this part of the volatility cycle will look nothing like what we have all grown accustomed to during the low volatility period between 2013 and 2019. As we stated in our already referenced paper, "Crash or Consolidation", we believe this transition in volatility marks the official beginning of the phase we described. Investors in equity markets will likely experience less than average returns over the next 10-20 years.
Investors and allocators should accept the reality of market cycles and the risk and reward of equity investments. However, volatility can be harnessed and delivered as an investment in its own right and is not necessarily reliant on market direction–a much needed dynamic for the period ahead.