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Vanguard: Where’s the Volatility?


One of my favorite commercials of all time was the Wendy’s ad where the size of the burgers from competitors was criticized. The famous line “Where’s the beef?” has stuck in my head ever since. Today, I read the paper and see headlines proclaiming volatility, volatility, volatility, and I can’t help but hearing that tagline in my ear, “Where’s the volatility?”

Since the start of 2012 through the first few weeks of 2013, stocks have enjoyed strong returns, coupled with modest volatility. Indeed, despite the headlines stemming from Europe, the uncertainty leading up to the U.S. presidential election, and the 11th hour aversion of the “fiscal cliff,” U.S. equities only experienced minor speed bumps on their path toward an average 21% total return.

Of the 274 trading days, only 7 saw prices move more than 2% and, of those, only 3 were days when prices fell by more than –2%. Compared with long-term history, those 7 days are less than half the average (17 days) for 2% moves in a calendar year. In addition, VIX (the CBOE Volatility Index, based on S&P 500 Index Options)—the so-called “fear gauge”—has fallen to levels commonly associated with tranquil markets. In fact, on January 18, VIX fell below 13 (off –31% since year-end 2012), a level last achieved in mid-2007. [Dow 14,000: The Death of Volatility ETFs?]

Regardless of the measurement used for volatility, it is important to understand that market volatility is primarily driven by significant and unpredictable changes in the global macroenvironment. Because volatility ebbs and flows with these unpredictable macrodevelopments, volatility itself can be very volatile as new information is priced into current market values. As we have seen throughout history, the regime at any moment can change and change significantly in a short period of time.

For example, in the months preceding August 2011, the investment markets were experiencing positive returns coupled with low levels of volatility. At the same time, there was a fast-approaching event, known as the debt ceiling. The debt ceiling debate eventually led to a credit-rating downgrade by a major rating agency.

Then on August 8, the next trading day following the downgrade, VIX spiked to 48, more than two times greater than the long-term average since 2000, and stock prices fell rather quickly. The following months were marked by a fairly extended period of heightened volatility in the equity markets until year-end when it swiftly and significantly declined, as shown below in the figure. The net result? For 2011, the S&P 500 Index returned only 2% (if you reinvested dividends), coupled with periods of significant volatility.


So where are we today?

Today, uncertainty remains. The U.S. economy, Europe, and the political infighting surrounding the “grand bargain” remain noteworthy question marks. So what can investors expect? Without a crystal ball, no one truly knows. However, we can draw from past experience and intuition to help prepare investors for any potential outcome. One thing we do know is that periods of low volatility (like periods of high volatility) do not last.

Of course, it bears repeating that we have no idea how the markets will react to the next macroevent, positive or negative. However, what we do know is that macroeconomic shocks are nothing new, and each time one has occurred, there has been an accompanying spike in volatility. What’s also true is that once a “shock” has been alleviated, the markets return to more normalized levels. For example, in March 2012, we wrote about how far volatility had declined. Over one 30-day period in March, volatility in the equity market was lower than 78% of periods since 1964.

We also know that ETFs can hardly be the culprit in these periodic spikes in volatility. We have previously shown that ETF trading volume as a percentage of all trading volume in the market historically has been uncorrelated with volatility and that spikes in volatility have occurred when ETF market share was generally on the decline.

How to prepare?

Control what you can control! Investors who maintain a proper allocation to low-cost, diversified stock and bond investments have the best weapons to combat periods of high volatility. Importantly, high-quality fixed income assets can help to mitigate the risks posed by global macroevents on equity holdings. Those investors who have determined an appropriate asset allocation, who employ broad diversification, and who rebalance when necessary have historically weathered periods of excess volatility better than those who don’t.

Fran Kinniry, CFA, is a principal in Vanguard Investment Strategy Group.

I would like to thank my colleagues Chris Philips and Todd Schlanger for their contributions to this blog post. This commentary represents a continuation of the research that we have produced concerning market volatility.