Reminding ourselves of just how unusual the current absence of volatility in equity markets is can help us prepare for the inevitable instability.
As I write, stockmarkets are in the midst of an eerie calm. It’s worth understanding the historical context to grasp just how extraordinary today’s conditions really are. Equity volatility in the US and Europe has collapsed to the lowest levels on record.
US stocks have gone more than 325 trading days (well over a year) without a correction of more than 5 per cent. That’s unusual, if not unprecedented: we have seen extended periods without a significant fall happen before, once in the 1960s and in two long stretches in the mid-1990s.
Even smaller market bumps have become vanishingly rare – fluctuations of more than 1 per cent on a daily basis are now few and far between. Looking at the S&P 500 index in the US, again data back to the 1950s shows that the market rose or fell by more than 1 per cent on an average of around 40 days a year, almost once a week, indicating that this sort of movement was normal.
In more volatile times, such as the mid-1970s, the tail-end of the dotcom boom and the 2008/09 crisis, we saw markets move by 1 per cent or more on well over 100 days a year. Given that there are around 250 trading days in a year, that’s almost half the time. There have been periods of relative calm in recent memory, but nothing like this. We have seen just eight days this year when the US stock market has moved by 1 per cent or more in either direction and not a single day when it has moved by more than 2 per cent. No fund manager working today has seen anything like this in their professional lifetime.
There is time yet for volatility to return, but if it does not, 2017 will stand (on this measure) as the least volatile year in more than 50 years. We have to go back to 1963/65 to find the only other similar stretch since 1950, when there were three years of incredibly calm markets, with only a handful of 1 per cent days in each of those years. Such calm cannot last, of course. That particular stretch was followed by a 20 per cent fall through 1966. Most Brits tend to remember that year for other reasons, but in US financial circles it’s remembered as the start of a grinding sideways bear market that lasted for more than a decade. As late as 1978, the S&P 500 index traded below the level seen at the end of the mid-1960s’ dead calm.
While there’s no reason to suggest today’s period of calm will result in anything similar – stocks were hit in the 1970s by a sustained rise in inflation that looks very unlikely in today’s global economy – it is, at least, a useful reminder that nothing lasts forever.
Theories abound as to why stock markets are so calm. But as ever in markets, there is no definitive explanation for precisely why what’s happening is happening. Some point the finger at quantitative easing (QE), with central bank action dampening market volatility (why worry if central bank chiefs such as MarioDraghi and Janet Yellen are guarding your back?). Others suggest that investors remain under-risked, still scarred by 2008 and wary of the next crash. As a downturn fails to occur and the equity market bears give up on waiting for disaster to strike, there is a ready supply of buyers for every market dip, no matter how small.
Optimists, meanwhile, might argue that more robust and sophisticated risk management across investor portfolios has helped, allowing institutions to calibrate their risk-taking effectively and adopt a very sanguine view of the world. This, however, seems unlikely; if anything, widespread adoption of similar risk management systems could encourage herd-like behaviour in a sudden sea change in the market environment, as investors’ risk models recalibrate for an evolving market regime. Many different investors reacting to a sudden bout of volatility by trying to sell assets in a hurry could lead to much bigger changes in asset valuations than seem justified by fundamentals – the deep correction in early 2016, just 18 months ago, was a prime example of this.
Others have suggested that today’s calm simply reflects a kind of ‘shock fatigue’. The past decade, and maybe the past year or two in particular, have seen so many unthinkable surprises that investors have become inured to shock. Markets, central banks and politics have twisted and turned so much that the seemingly impossible has become commonplace, or so this theory goes. Who would have predicted 10-year government bonds with negative yields or central banks cutting interest rates below zero and buying trillions of US dollars worth of bonds, and the political shockwaves of Trump and Brexit? Have we really reached a point where markets have seen it all and cannot now be surprised? It seems unlikely.
The stately progress of stock markets continues to see investor inflows, driven perhaps by fear of missing out on the positive momentum and possibly by the low volatility environment itself: when volatility is low, some investors may be tempted to take a little more risk than normal. This means low volatility is running hand in hand with more expensive asset valuations, not just in equities but right across capital markets.
Many investors would regard government bonds as expensive, with yields below inflation in most markets. We see a little value in US Treasuries, but very little in other government bond markets. Pockets of value in other areas of bond markets, particularly corporate bonds, are getting harder to find: high-yield bonds were outstanding value 18 months ago, as markets panicked about low oil prices and misplaced fear of a US recession intensified, but not so much now.
In equity markets, US stocks look expensive, inflated by the rich valuations of technology stocks in particular. But there are still regions where stocks look inexpensive: pricing looks reasonable in Europe, Japan to some extent, and less heavily trodden corners of global markets such as frontier markets and micro-caps. And in most markets, our allocations lean towards systematic value strategies that favour cheaper stocks in any given sector.
Valuations may not, of course, be a very good signal for what stock markets will do in the short term. Stocks can stay excessively cheap or expensive for a long time before a catalyst shifts investor behaviour. But when investor behaviour does eventually shift and volatility breaks out, the most demandingly valued segments of the market could be the most vulnerable.
We might observe that markets are behaving in a highly unusual manner, but how does this help us? After all, today’s record low levels of volatility may be unusual, but conditions such as this can persist for long enough to be very painful for any investor who predicts a change of environment and positions for it much too early.
We are already very familiar with this dilemma. Our portfolios are currently tilted somewhat towards caution, as we try to balance a fairly benign economic environment against demanding asset valuations. Observing today’s dead calm in markets gives us little insight on when the financial weather will change, but reminding ourselves how unusual current conditions are encourages us to be prepared for the inevitable when it does come.
Causes of a shift in the market environment can be hard to predict. But if QE has been one of the causes of low volatility, we might approach the next couple of months with a little trepidation if belief is growing that growth is robust enough to support a return to more normal monetary policy. In such a world, market volatility might creep upwards slowly and stock market valuations remain at high levels, but investors should consider the alternative. A sudden squall of volatility would remind investors that today’s dead calm is highly unusual, potentially raising uncomfortable questions about valuations in more expensive areas.
Alex Scott is deputy chief investment officer at Seven Investment Managment.
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