For Market Volatility, No News Is Good News

The first decade of the 21st century is over, and according to market consensus, so is the 2008 market-crash event.

Volatility declined sharply for the second consecutive quarter -- down 39% from Q3 2010 to Q4, following a 30% drop from Q2 to Q3. It's now running well below normal for the first time since the 2008 crash. 

Since its inception in 1957, the S&P 500 index has experienced an average daily change of plus or minus 0.62%. Volatility hit an all-time high in Q4 2008 -- breaking the record set in 1929 -- with mind-boggling peak average daily change of plus or minus 3.27%. (That's a whopping 427% above the average.) For the year, it was a record plus or minus 1.71%, or 175% above average.

In 2009, volatility declined to plus or minus 1.19% -- still 92% above average -- and in 2010, overall volatility was down to plus or minus 0.74%. The trendline is clearly down, culminating in the fourth quarter's plus or minus 0.48%, the lowest volatility reading for a quarter in more than three years.

I track market volatility because it's a reasonably reliable gauge of risk levels. Roughly 80% of the time, when volatility in the S&P 500 goes up -- when the average annual daily change in the price of the index (up or down) is greater than it was in the prior year -- market performance for that year declines compared to the prior year. And when volatility declines year over year, market performance improves 60% of the time.

(In fairness, that wasn't the case in 2010. Despite lower volatility, the market was up only 13%, compared to a 23% rise in 2009.) 

The following chart shows the quarterly fluctuations in volatility levels for the S&P 500 from a year before the crash -- the fourth quarter of 2007 -- to the present, compared to volatility measurements of the Dow Jones Industrial Average from a year before the 1929 crash. (I use Dow volatility data for the 1929 crash because the S&P 500 was not around back then.)

Of course, the fourth quarter of 1929 was just the beginning of an extended period of market decline that persisted for years. Consistent with my research into the relationship of market volatility and performance, volatility levels in the 1930s continued to surge well above normal. Thus, it is encouraging that the trendlines have been diverging for the past two years, and the break to below-normal volatility levels this past quarter -- something that never came close to happening in the three years of post-1929 crash data -- is particularly bracing.

It's important to keep in mind that volatility is not a leading indicator; black swan events engender volatility, not the other way around. Should California or Portugal default, should North Korea launch a nuke-tipped ICBM, should a deadly and contagious avian flu sweep the planet, or any equivalent event occur, then all bets are off.

But for what it's worth, the current consensus of U.S. investors appears to be that the worst is behind us, and that risk levels going forward are no longer elevated.

For my past coverage of market volatility:

Brad Hessel is a guest contributor to Fool.com. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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  • Report this Comment On January 12, 2011, at 8:58 PM, ChrisBern wrote:

    The article is a good summary of volatility.

    "I track market volatility because it's a reasonably reliable gauge of risk levels."

    When I think of risk, I think of the potential to lose capital. So to me a better gauge of risk is valuation, not volatility. Right now the market's cyclically-adjusted P/E ratio is 43% higher than the historical mean (multpl.com). That, to me, is a VERY risky market

    Markets that were this overvalued have historically done quite poorly in the ensuing quarters and years. The only short-term exception was when the market was similarly overvalued circa 1995, and become even more overheated over the next 5+ years. Of course it all crashed in early 2000, so it was a short-term exception. No market that was this overvalued has ever avoided losing money--in fact it always has lost money within 12 months (except the 1995 exception).

  • Report this Comment On January 12, 2011, at 11:54 PM, bhessel wrote:

    ChrisBern,

    Good comment. The quote you spotlight could have been better phrased: “I track market volatility because it’s a reasonably reliable gauge of PERCEIVED risk levels” would have done the trick.

    At Intelledgement, our approach is macro analysis. From that perspective, we see giant multi-national banks that are still stuffed with toxic assets and riding for a fall, a USA real estate market with property values that are still overvalued, developed economy consumers who are still underemployed and overleveraged (especially in the USA), fast-growing emerging market economies that are by their very nature vulnerable to bubbles, and material sovereign debt risk. And, unfortunately, regardless of whether we put Republicans or Democrats in control of the government, our political leaders seem invariably intent on treating the symptoms of our illness, avoiding challenges to any entrenched elites, and hoping and praying they can muddle through with no ultimate crisis on their watch…even at the cost of leaving us with fewer resources to deal with our structural problems when we finally run out of effective delaying tactics.

    So, in short, we don’t think things are back to normal. But stock market investors sure seem to.

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